Ebook Monetary Policy In A World With Different Financial Systems
Different countries and currency areas are typically characterized by different financial structures, as a result of history, legal frameworks, collective preferences, politics. Financial structures are in turn among the key determinants of bank and asset risks. Micro data for industrialized country show differences in banking systems in terms of return on assets, loan loss provisions, availability of external finance and efficiency indicators. At the same time, remarkable asymmetries in economic fluctuations have been documented across industrialized countries mostly during the last decade. For instance some countries like the UK and the US have highly correlated business cycle fluctuations, while other regions like the US, the Euro area and Asian countries are characterized by low or negative correlations over the cycle.
Financial markets may play a role in shaping the patterns of international transmission of shocks across countries. However, asymmetries in the financial systems and corporate risk have not been incorporated in the analysis of the international transmission of shock and of macro policy interdependence. The open economy literature has studied international business cycle properties under different settings, but very little work has focused on the role of financial fragility and even less on the effect of asymmetries in such fragility. This paper explores this concept and argues that financial diversity can account for heterogenous business cycle fluctuations and help to explain some of the features of the international transmission mechanism across countries.
To this aim I, first, present evidence of the presence of differences in financial markets and for the fact that they account for asymmetries over the business cycle. Data show that a negative and significative relation exists between the correlation of output gaps and financial gaps, defined as the difference between indicators of banking efficiency . Secondly, I examine an artificial economy with two countries characterized by different degree of financial fragility and identical policies that allows me to isolate the effect of financial differences over the business cycle. I use a two country model of stochastic dynamic general equilibrium with optimizing agents characterized by nominal rigidities in an imperfectly competitive framework, international financial markets for deposits, loans and state contingent bonds, and financial diversity in terms of fragility of banking systems and riskiness of investment projects. The reason for which sticky prices are introduced in the model is to allow a meaningful comparison between floating and fixed exchange rate regimes . Financial fragility is introduced via borrowing constraints on investment due to the presence of asymmetric information between borrowers and lenders. Financial differences are modelled in terms of cost of bankruptcy, riskiness of investment projects and failure probability of firms; these elements are in turn determinants of the return on asset, the size of the loan loss, the size of the borrowing limit and its elasticity with respect to collateral and conditions of external finance. The sensitivity of the borrowing limit to the conditions of collateral and external finance is the key determinant of link between financial fragility and business cycle. The paper studies dynamic responses quantitative statistics and welfare costs for productivity and financial shocks. The analysis compares asymmetric versus symmetric and correlated shocks.
The model is calibrated on the US and the Euro area, for two reasons. First, the macroeconomic and policy interactions between these two areas have become, after the creation of the euro in 4999, the key issue in international economics. Second, the asymmetries in the financial structure between these areas are well documented, and have often been advocated to explain the differences in the domestic transmission mechanism of monetary policy. Nonetheless, the focus on the US and Europe is to some extent illustrative. The basic model presented in this paper can be used to analyze a number of other important issues, such as the implication of Japan’s financial fragility on the international transmission process, or the macroeconomic interactions between financially asymmetric countries that are linked by a hard peg (e.g. a currency board).
To completely assess the role of financial differences I analyze their role under different specification of the monetary regimes and policy rules and under different degrees of economic and financial integration. I first consider a regime of independent monetary policies, with a floating exchange rate, specified in two alternative ways: Taylor rules and rigid inflation targeting rules. When the monetary authority adopts the rigid inflation targeting rule it applies an infinite weight to domestic inflation in the limit this rule implies that the nominal interest rate is set on a period by period basis equal to the wicksellian interest rate that reacts to state variables such as net worth of firms. I then consider also a regime of credible pegs. I explore the role of economic openness, defined as the ratio of exports over GDP, and financial openness, defined as the ratios of loans denominated in foreign currency, to see whether higher trading and financial interlinkages can contribute to amplify heterogenous business cycle responses. To complete the analysis of the impact of financial differences on the international transmission mechanism I analyze the relative pattern of interest rates and the dynamic of the exchange rate to show that the introduction of borrowing constraints can be useful to match some stylized facts.
I find that differential responses occur under identical and independent policies even under low degrees of economic and financial openness. The correlations of output gaps decrease when financial differences among countries increase. This result is robust to different parametrization. It holds for any kind of shock i.e. asymmetric, symmetric and uncorrelated, symmetric and correlated. The negative relation found in the model recall the one in the data.
The intuition for this result in the model is linked to the role of financial asymmetries. Having different degree of borrowing constraints generates different degrees of persistence and volatility for the responses of variables even with symmetric and correlated shocks.
With asymmetric shocks the model is able to reproduce a wide range of correlation values i.e. from positive to negative - depending on the degree of difference between financial systems. In traditional models of open economy literature asymmetric shocks would always generate negative correlations of output as a consequence of the demand shift between the two countries. Since data show that positive correlations can occur also under asymmetric shocks this result could be partly considered a puzzle. The transmission mechanism of the present model is instead enriched with an “indirect financial spillover” effect. For instance when a positive technology shock hit the home country the demand shift between domestic and foreign goods induces a decrease in foreign inflation; the consequent decrease in interest rates and in the cost of the loans generates an increase in asset prices and investment in the foreign country. This positive financial effect associated with the international transmission mechanism of the present model can partly or completely offset the negative impact of the demand shift on the foreign country business cycle. The magnitude of the indirect financial spillover will depend on the relative degree of financial differences between the two countries. When the two countries have similar financial systems the positive financial spillover is able to offset the negative switching expenditure effect and consequently to generate positive correlations.
Synchronization in economic fluctuations is more pronounced under unilateral and bilateral credible pegs; when a fragile country sets the same interest rate of a more stable country asymmetric responses are reduced.
Some other features of the international transmission mechanism follow from the study. First, by adopting a rigid inflation target the monetary authorities of the two countries induce higher volatility of output and investment since the interest rates react to financial variables like net worth and spread financial instability to the all economy. Second, the persistence of the real exchange rate increases when differences in borrowing constraints increase. Increasing differences in borrowing constraints generate increasing differences in the persistence of real interest rates; the gap in the interest rates persistence is absorbed by the real exchange rate through the uncovered interest rate parity. Finally I explore the welfare implications and I show that external and correlated financial shocks result in higher welfare losses for the country that is more fragile in terms of risk perception.
The paper is organized as follows. Section 2 presents some statistical evidence, documenting the presence of differences in financial markets and their link with asymmetries over the business cycle. Section 3 presents the model economy. Section 4 includes the results. Conclusion, tables, graphs and appendices are reported at the end of the paper.
Contents
Abstract
Non-technical summary
1 Introduction
2 Evidence for the presence and the effect of heterogenous financial markets
3 A model economy with financial heterogeneity
- 3.1 Workers behavior in home and foreign country
3.2 The entrepreneurs in the home and foreign country
3.3 The production sector
3.4 The financial intermediary and differences in financial systems
3.5 The equilibrium conditions
4 The monetary policy rules
5 Calibration
6 Financial asymmetries with identical policies
7 Conclusion
References
Appendix
8 Solution of the contract in the steady state
9 The steady state of the economy
10 The competitive economy
- 10.1 The open economy relations
10.2 The competitive equilibrium relations
10.3 The loglinearized version of the model
11 The welfare measure
12 Volatilities of the model
Figures & Tables
European Central Bank working paper series
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