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Porfolio Shocks The Portfolio Channel of Capital Flows: A Small Open Economy Approach Carlos Montoro (BCRP) & Marco Ortiz (Universidad del Pac fico) Presented by: Marco Ortiz 2020 First Conference on Financial Stability and
Porfolio Shocks
The Portfolio Channel of Capital Flows: A Small Open Economy Approach
Carlos Montoro (BCRP) & Marco Ortiz (Universidad del Pac´ ıfico) Presented by: Marco Ortiz
2020 First Conference on Financial Stability and Sustainability ma.ortizs@up.edu.pe
Marco Ortiz January 2020 1/29
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Contents
Motivation The Model Results Conclusions
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Motivation
◮ Exchange rate determination has been one of the major puzzles in
International Macroeconomics.
◮ Meese & Rogoff (1983): Asset price models fail to explain variations in
exchange rates.
◮ Meese (1990): The proportion of exchange rate fluctuations that
current economic models can predict is essentially zero.
◮ Microestucture Approach: Evans & Lyons (2002), Payne (2003) find a
strong positive between order flow and returns in the FX market.
◮ Breedon & Vitale (2010) show that the order flow impacts in the
returns of the exchange rate through portfolio and and information channels.
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Motivation (2)
◮ Microstrucure in th FX Market
◮ Lyons (1997), Evans & Lyons (2004), Bacchetta & van Wincoop
(2006), Hau & Rey (2006), Breedon & Vitale (2010) present models
◮ FX Intervention
◮ Vitale (2011): FXI model with a signalling a a portfolio channel. ◮ Vitale (2003): FXI and monetary policy model.
◮ None of these models is full-scale SOE NK-DSGE model.
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Motivation (3)
Figure 1: FX Intervention - Selected Countries (2002 - 2016)
Source: Domanski, Kohlscheen & Moreno (2016) Marco Ortiz January 2020 5/29
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Motivation (4)
◮ The workhorse SOE NK-DSGE used by central banks for policy
analysis regularly assumes that the exchange rate is determined by a UIP condition and that the foreign position for domestic currency bonds is zero.
◮ We observe in the data that the position of non-resident investors in
domestic currency bonds shows a strong correlation with the exchange rate.
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Motivaci´
Figure: Non-Resident Investor Holdings in Fixed Return Market and Nominal Exchange Rate (PEN/USD)
Source: BCRP Marco Ortiz January 2020 7/29
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Motivation (6)
Questions that we need to address
◮ How does portfolio changes affect the economy? ◮ How does FXI operates? ◮ What are the channels? ◮ What is the optimal monetary and FXI policy design? ◮ Do results change when we move from partial equilibrium to a fully
scale SOE NK-DSGE model?
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What has it been done?
FXI in DSGE Models:
◮ Montoro & Ortiz (2013), Benes et al. (2015), Vargas et al. (2013),
Escud´ e (2012), Blanchard et al. (2015); Cavallino (2015); Engle (2011); Adler, Lama & Medina (2016); Fanelli & Straub (2016); Gabaix & Maggiori (2015), Chang (2018); Itskhoski & Muhkin (mimeo).
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What do we do?
1) Extend the standard NK SOE DSGE model to incude:
◮ A market of FX dealers. ◮ An explicit role for FX volatility. ◮ An explicit role for Non-Resident portfolio holdings. ◮ An interaction between monetary and FXI policies.
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What do we find? (ongoing)
Porfolio shocks...
◮ impact FX markets and are transmitted to the rest of the economy. ◮ though the portfolio channel has an additional stabilization role
through the current account. FX intervention...
◮ Is a useful instrument for the stabilization of the economy. ◮ The stabilization role goes beyond offsetting the portfolio shocks. ◮ There are important interactions between monetary and FXI policies.
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The Model ◮ NK-SOE DSGE with an FX market composed by risk averse dealers. ◮ Each dealer d pays the domestic interest rate it for the household assets
for one period (myopic) and invest in foreign and domestic assets. Dealers maximize:
max
̟ι,d,∗
t
−Ete−γΩι
t+1
where Et is the rational expectations operator, γ is the absolute risk aversion coefficient. Ωι
t+1 is the total return in domestic currency of the
portfolio, given by:
Ωι
t+1 = (1 + it)̟d,ι t
+ (1 + i∗
t )St+1̟ι,∗,d t
− (1 + it)
t
t
+ (1 + i∗
t )St+1̟ι,∗,d t
− (1 + it)
t
+ St̟ι,∗,d
t
t − it + st+1 − st)̟ι,∗,d t
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The Model (2)
◮ Each individual dealer d demand for foreign currency is given by: ̟ι,d∗
t
= i∗
t − it + Etst+1 − st
γσ2
where σ2 = vart (∆st+1) is the unconditional variance of the exchange rate. We assume this variance as a constant, determined by the volatility of shocks and the FXI policy.
◮ Aggregating across dealers we obtain a modified UIP condition: Etst+1 − st = it − i∗
t + γσ2(Bd,∗ t
)
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The Model (3)
◮ Non-resident investors (or carry traders) will have an exogenous
demand for domestic bonds.
Bc
t + StB∗,c t
= 0
where:
Bc,∗
t
=
t−1
ρbc,∗ exp(εbc,∗
t
) ◮ The non resident investors will requiere to increase the supply of
foreign currency instruments to increase their domestic currency portfolio.
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Central Bank ◮ We introduce a Central Bank, which intervenes in the FX market (in addition
to its inflation stabilization role.) The balance sheet of the Central Bank is given by:
StBcb,∗ + Bcb
t = M s t + NW cb t
◮ where Bcb,∗
t
represents the NIR and Bcb
t
are the bonds issued by the central bank. M s
t is the money supply and NW cb t
represents the Central Bank’s net worth. Its flow constraint is given by:
Bcb
t+1+St+1Bcb,∗ t+1−M s t+1+PtΓcb t = (1+icb t )Bcb t +(1+icb,∗ t
)St+1Bcb,∗
t
−M s
t
where Γcb
t
are the transfers to families.
◮ We abatract from central bank’s net worth and money supply and assume: Bcb
t + StBcb,∗ = 0
◮ Thus, when the centrla bank sells foreign instruments, it will do so against
domestic currency ones, sterilizing all FXI.
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Bond Market Equilibrium and the Current Account ◮ Domestic bonds market equilibrium: Bd
t + Bcb t + Bc t = 0.
◮ Holdings of foreign currency bonds by dealers (families) are determiend by
the current account (log-linearized):
φb
t − β−1bcb t−1
rert + b∗
t − β−1bt−1
. . . + φb∗,cb
t
− β−1bt−1
= tdef
t
+ yt − φCct + φb + φbcb β (it−1 − πt) + φb∗ + φb∗,cb β
t−1 + rer − π∗ t
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FX Intervention
◮ “Discretion” benchmark: B∗cb
t
= εcb,0
t
◮ Nominal exchange rate rule: B∗cb
t
= −φ∆s∆st + εcb,1
t
◮ Reaction to Portfolio shocks: B∗cb
t
= −φrerrert + εcb,2
t
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Other equations of interest
◮ Aggregate demand (yt) yt = φC(ct) + φX(xt) − φM(mt) + gt
(1)
◮ Real exchange rate (rert) rert = rert−1 + ∆st + π∗
t − πt
(2)
◮ Total CPI (πt): πt = ψπH
t + (1 − ψ) πM t
+ µt
(3)
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Other equations of interest (2)
◮ Domestic goods Phillips Curve (πH
t ):
πH
t = κH
t
t+1
(4)
◮ Imported Goods Phillips Curve (πM
t ):
πM
t
= κMmcM
t
+ βEtπM
t+1
(5)
◮ Exported Goods Phillips Curve (πX
t )
πX
t = κXmcX t + βEtπX t+1
(6)
◮ Taylor Rule (it) ˆ ıt = ϕπ(πt) + ϕy(yt) + εint
t
(7)
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Baseline Calibration
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Results (1) - Equilibrium
(a) No Intervenci´
(b) Intervenci´
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Results (2) - Rules vs. “Discrection”)
1 2 3 4 5 6 7 8 9 10 Quarters after shock(c) Int. Rule 1
1 2 3 4 5 6 7 8 9 10 Quarters after shock(d) Int. Rule 2
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Results (3) - Rules vs. “Discretion” (Portfolio Shock)
1 2 3 4 5 6 7 8 9 10 Quarters after shock(e) Int. Rule 1
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Results (4) - Monetary Policy under rules (Interaction)
1 2 3 4 5 6 7 8 9 10 Quarters after shock(f) Int. Rule 1
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Results (5) - Optimality (ongoing)
◮ FXI impacts the economy in the expected direction: A forieng
currency purchase by the CB generates a depreciation...
◮ though, we are silent reagarding optimality.
◮ As a first approximation to the problem we generate a grid over Taylor
rule paremeters (ϕy, ϕπ) and FXI reaction (ϕ∆s).
◮ Notice that exchange rate equilibrium volatility will vary with each set
reach in each point of the grid in the space (ϕy, ϕπ, ϕ∆s)
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Results (6) - Optimality
1.5 1 1.4 y 2.2 1.6 2 0.5 1.8 1.8 2 + 2 y 10-4 2 1.6 2.2 1.4 1.2 2.4 1(g) No Int.
1.5 1 2 y 2.1 2.2 2.2 2 0.5 2.3 1.8 10-4 2 2 + 2 y 2.4 1.6 1.4 2.5 1.2 2.6 1(h) Dep rule
Note: Figure shows the value of an ad hoc loss function for the Central Bank of the form L = 2 × σ2
π + σ2 y for different values of parameters in the monetary
policy function ruling the central bank’s reaction to inflation (φπ) and the output gap (φy).
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Results (7) - Optimality
(i) No Int. (j) Dep rule
Note: Figure shows the equilibrium variance of the exchange rate (σ2
∆s) for each
combination of the Taylor rule parameters depicted in the respective upper figure.
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Conclusions and Future Agenda
◮ We present an alternative model of exchange rate determination in
general equilibrium that can be useful:
◮ to explain certain puzzles in the literature of the New Open Economy
Macroeconomics.
◮ for policy analysis (central banks).
◮ Our results for FXI in general equilibrium show:
◮ Effective as an instrument in face of financial shocks, but not so much
in face of real shocks or nominal external shocks;
◮ FX intervention rules can have stronger stabilisation power than
discretion as they exploit the expectations channel;
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The Portfolio Channel of Capital Flows: A Small Open Economy Approach
Carlos Montoro (BCRP) & Marco Ortiz (Universidad del Pac´ ıfico) Presented by: Marco Ortiz
2020 First Conference on Financial Stability and Sustainability ma.ortizs@up.edu.pe
Marco Ortiz January 2020 29/29
Finance Department Universidad Diego Portales
A discussion for “The Portfolio Channel of Capital Flows: A Small Open Economy Approach” by Ortiz and Montoro
Taylor, D. (1982). Official intervention in the foreign exchange market, or, bet against the central bank. Journal of Political Economy, 90(2), 356-368.
Z-score weekly fund flows (2007-2014)
Stracca & Refet (2012);