The growth of emerging economies and global macroeconomic stability - - PowerPoint PPT Presentation

The growth of emerging economies and global macroeconomic stability

Vincenzo Quadrini University of Southern California June 21, 2015

0.2 0.4 0.6 0.8 1 1.2 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013

GDP of Emerging Countries Relative to Industrialized Countries

At Parchasing Power Parity At Nominal Exchange Rates

‐0.3 ‐0.2 ‐0.1 0.0 0.1 0.2 0.3 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Net Foreign Position in Debt and Reserves (Percent of GDP)

Emerging Countries Industrialized Countries

QUESTION

How does the growth of emerging economies affect the financial and macroeconomic stability of both emerging and industrialized countries?

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ADDRESSING THE QUESTION

• 1. I develop a two-country model where global banks play a central role.
• 2. Emerging countries have a greater demand for financial assets.
• 3. The model generates financial crises induced by self-fulfilling expectations

about the liquidity of the banking sector.

• 4. I then use the model to study how the growth of Emerging Economies

affects macroeconomic stability.

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PREVIEW OF RESULTS

• The increased size of emerging countries increases the world demand for

liquid assets (bank liabilities in the model).

• This reduces the interest rate paid by banks and creates an incentive for

banks to leverage.

• The higher leverage increases financial fragility: higher probability of a

crisis and/or the macroeconomic consequences of a crisis.

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THREE SECTORS MODEL

• 1. Entrepreneurial sector
• 2. Worker sector
• 3. Financial intermediation sector

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• 1. Entrepreneurial sector
• Continuum of entrepreneurs with utility E0

∞

t=0 βt ln(ci t)

• Technology F(zi

t, hi t) = zi thi t

hi

t = Input of labor

zi

t = Idiosyncratic shock observed after choosing hi t.

• They can buy bonds bi

t+1. The budget constraint is

ci

t + bi t+1

Rb

t

= (zi

t − wt)hi t + bi t ≡ ai t

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Optimal entrepreneur’s policy

hi

t

= φ(wt)bi

t

ci

t

= (1 − β)ai

t

bi

t+1

Rb

t

= βai

t

Where φt satisfies Ez

• z−wt

1+(z−wt)φt

• = 0.

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Aggregate demand of labor Ht = φ(wt)

• i

bi

t

• Financial wealth

✲ ✻

wt Ht

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Aggregate demand of labor Ht = φ(wt)

• i

bi

t

• Financial wealth

✲ ✻

wt Ht

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• 2. Worker sector
• Continuum of workers with utility E0

∞

t=0 βt

• ct − α¯

zt

h1+ν

t

1+ν

• They hold a non-reproducible asset in fixed supply K, traded at price pt.

Each unit produces χ¯ zt units of consumption goods.

• They can borrow subject to the collateral constraint

lt+1 Rl

t

≤ ηEtpt+1kt+1

• Budget constraint

ct + lt + (kt+1 − kt)pt = lt+1 Rl

t

+ wtht + χ¯ ztkt

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First order conditions for workers

αhν

t = wt

1 = βRl

t(1 + µt)

pt = βEt

• χ + (1 + ηµt)pt+1
• 12

Aggregate supply of labor Ht = wt

α

1

ν

✲ ✻

wt Ht

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EQUILIBRIUM WITHOUT INTERMEDIATION (Borrowing and lending is direct)

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LABOR MARKET EQUILIBRIUM

✲ ✻

wt Ht Labor supply HS

t =

wt

α

1

ν

Labor demand HD

t

= φ(wt)Bt

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LABOR MARKET EQUILIBRIUM (Lower stock of bank liabilities)

✲ ✻

wt Ht Labor supply HS

t =

wt

α

1

ν

Labor demand HD

t

= φ(wt)Bt

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INTRODUCING THE INTERMEDIATION SECTOR

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Schematic overview of the economy

Financial Intermediaries Net borrowers (Workers) Net savers (Entrepreneurs/ producers) Consumption Labor supply Consumption Hiring

• 3. Intermediation sector
• Banks start with liabilities bt and loans lt.
• The liquidation value of bank assets is ξtlt, with ξt ∈
• ξ, 1
• .
• Banks renegotiate if liabilities exceed the liquidation value of assets,

˜ bt(bt, lt) =

• bt,

if bt ≤ ξtlt ξtlt if bt > ξtlt

• There is an intermediation cost that rises with leverage.

˜ ϕt(bt+1, lt+1) = ϕ bt+1 lt+1 − ξ

• bt+1

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LOW LEVERAGE (No default)

lt ξ lt

✻

bt

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HIGH LEVERAGE (Possibility of default)

lt ξ lt

✻

bt

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Bank’s problem

Vt(bt, lt) = max

dt,bt+1,lt+1

• dt + βEtVt+1(bt+1, lt+1)
• subject to

˜ bt(bt, lt) + ˜ ϕt(bt+1, lt+1) + lt+1 Rt + dt = lt + Et˜ bt+1(bt+1, lt+1) R

b t

First order conditions

1 Rb

t = β

• 1 + Φ
• bt+1

lt+1

• 1

Rl

t = β

• 1 + Ψ
• bt+1

lt+1

• 22

Two-countries: The growth of emerging economies and global imbalance

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Cross-country heterogeneity

• 1. Differences in size:
• Productivity, ¯

zj

• 2. Differences in financial market characteristics:
• Volatility of the idiosyncratic shock, σj
• Borrowing limit, ηj

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SIMULATION EXERCISE

• Country 1: Industrialized economies. Country 2: Emerging economies.
• Relative productivity ¯

z2 ¯ z1 changes over the period 1991-2013.

• Model simulation repeated 1,000 times. In each simulation:

– Same sequence ¯

z2 ¯ z1;

– Different sequences of random draws ξ.

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CALIBRATION (Based on early 1990s data)

• Quarterly model with β = 0.985.
• Working dis-utility parameter αj to have average labor equal to average

employment over population.

• Output from fixed asset χ to match share of housing services in GDP

Housing service share = χ Hj,t + χ

• Collateral parameter ηj to generate private credit to GDP in each country.
• Volatility of idiosyncratic shock σ1 = [0.7, 1.3], σ2 = [0.4, 1.6].

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CALIBRATION (Based on early 1990s data)

• Low realization of shock ξ = 0.85.
• Intermediation cost

ϕ(ωt+1) = τ +    0, if ωt+1 ≤ ξ (ωt+1 − ξ)2, if ωt+1 > ξ . Parameter τ chosen to target the share of finance in GDP.

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Calibration of relative productivity (Based on 1991-2013 data)

GDP2,t GDP1,t = ¯ z2,t ¯ z1,t H2,t + χ H1,t + χ

• .

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REPEATED SIMULATIONS

REPEATED SIMULATIONS

FOR A PARTICULAR SEQUENCE OF SHOCKS

• From 1991 to third quarter of 2008 the realization of the shock is HIGH.
• In the fourth quarter of 2008 the realization of the sunspot shock is

LOW.

• Afterwards, the realization of the sunspot shock is HIGH.

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SPECIAL SIMULATION

SPECIAL SIMULATION

CONCLUSION

• Cheap funding for banks creates an incentive to leverage.
• More leverage exposes the banking sector to crises.
• The growth of emerging economies pushes the globalized economy in

this direction raising financial and macroeconomic instability.

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