Ebook Why Financial Frictions and Currency Mismatches do not Affect Traditional Mundell!Fleming Results
Several authors have pointed out after observing the events in South/East Asia in 1997/8 that the presence of currency mismatches and credit market imperfections could be key elements to understand the financial crisis that affected these economies. A far from exhaustive list of researchers that first supported this argument includes Krugman (1999) and Aghion et al (2000). Implicitly in their work lies the idea that expenditure/switching effects as emphasized in the traditional Mundell/ Fleming textbook model can be counter/balanced by a debt burden of those agents indebted in foreign currency.
Whenever the latter effect is strong enough, the reduction in the value of the domestic vis a vis the foreign currency can generate a contraction in output (i.e., the balance/ sheet effect). This is, as Calvo and Reinhart (1999) argued, a reinterpretation of the debt/deflation argument popularized by Fisher (1933) but now in the context of small/open economie. Krugman and Aghion et al, however, only develop highly/stylized partial/equilibrium models in which the long/run dynamics are not considered.
In this regard, it is nowadays accepted that any well/respected macroeconomic model should be derived from primitive behavioral assumptions. This, in conjunction with budget constraints and some form of optimization process, allow the researcher to study the dynamic properties of the model in full. Along these lines of reasoning Obstfeld and Rogoff (1995) (henceforth OR) have been able to obtain the typical positive expenditure switching effects emphasized by Mundell and Fleming in a well/microfounded dynamic general equilibrium model. This paper has been influential not only because traditional Keynesian results were obtained from first economic principles, but also due to the high tractability of their model. It gave birth, moreover, to the so/called \New/Open/Economy/ Macroeconomics (henceforth NOEM) generation of models within international finance.
Whether traditional Mundell/Fleming results' also hold when currency mismatches and credit market imperfections are included in a NOEM/type of model has been an active area of research. Although this is not a novel question(, what is new is the fact that the recent literature almost entirely concentrates on financial channels where the presence of credit market imperfections is particularly emphasized. The latter is in turn rationalized by the presence of asymmetric information problems between lenders and borrowers. Broadly speaking, this literature combines three key ingredients: i. currency mismatches, ii. nominal price rigidities and iii. credit market imperfections.
Currency mismatches imply that certain agents in the economy, for some reason taken as given, have access to a credit market in which loans are essentially denominated in the foreign currency. Their assets, however, are denominated in the domestic currency or highly indexed to the domestic price index. The assumption about nominal price rigidities allows monetary or exchange rate policy to have non/trivial effects. Note also that the presence of prices that do not fully adjust after a policy shock is at the heart of the existence of balance/sheet problems: the local/currency indexation of domestic assets becomes restricted in such a case. In contrast, the domestic/value of foreign currency denominated liabilities freely adjusts with the nominal exchange rate. Indebted agents may suffer then a negative net worth effect as the exchange rate depreciates, thereby generating a contractionary effect on the economy.
The presence of credit market imperfections, moreover, will restrict the availability of credit and will also imply the existence of a risk premium which is inversely associated with the evolution of net worth. Therefore, there is an endogenous mechanism that amplifies shocks and affects the economy. This is in general modelled following two seminal contributions: Carlstrom and Fuerst (1997) and Bernanke et al (1999), which provide an elegant and relatively simple way of introducing financial frictions into an otherwise standard dynamic general equilibrium model.
Posted in :
