Financial Frictions, Monetary Policy, Exchange Rates

1. Financial Frictions, Monetary Policy, Exchange Rates Some Basic Issues

2. Introduction • Large changes in relative prices are often seen and create winners and losers • Examples: real estate prices, stocks and bonds, exchange rates • Conventional macroeconomics has largely ignored these • The view is that redistribution has negligible aggregate effects

3. Fisherian Deflation • Irving Fischer (1932): redistribution can have large relative and aggregate effects • In particular, if debts are written in nominal terms, deflation increases their real value • The resulting redistribution matters in the aggregate because debtors have a higher marginal propensity to spend than creditors

4. A modern rendition of Fisher’s argument: Eggertsson-Krugman • The basic idea: there is a set of debt-constrained agents, whose consumption falls sharply if their debt limit is reduced • While debts may be denominated in dollars, debt limits may be set in real terms • Aggregate demand can then fall if there is deflation

5. Basic Model • Two types of agents, with different discount factors (β(s) = β > β(b) ) • Log utility • Endowment: (1/2) Y per period

6. Budget Constraints Dt(i) = (1+rt-1 )Dt-1 – (Y/2) + Ct(i) (1+rt) Dt(i) ≤ Dhigh i = s, b

7. Steady state • Impatientagentborrows as much as he can: Cb= (Y/2) – (r/(1+r)) Dhigh • Output = consumption: Y = Cs + Cb  Cs = (Y/2) + (r/(1+r)) Dhigh

8. Patientagentisunconstrained: (1/Cts) = (1+rt) β Et (1/Ct+1 s) 1+r = 1/β in ss

9. “Crisis” • A sudden and permanentreduction in creditceiling to Dlow < Dhigh • In thelong run, theimpatientagentmustincreaseconsumption: CbL= (Y/2) – (r/(1+r)) Dlow = (Y/2) – (1-β)Dlow

10. In short run, borrowermust reduce consumption to satisfythe new debtceiling: Ds = Dhigh – (Y/2) + Csb • Key assumption: adjustmenttakesoneperiod: Ds =Dlow/(1+rs )  Csb= Y/2 + Dlow/(1+rs ) - Dhigh

11. In long run, patientagent consumes: CLs = Y/2 + (1-β) Dlow • In the short run, CSs = Y – CSb = Y/2 - Dlow/(1+rs ) + Dhigh • But CLs = (1+rs)βCSs

12. Negative interest rates • Combining, 1 + rs = (Dlow+Y/2)/β(Dhigh+Y/2) • rsisnegativeif βDhigh- Dlow> (1- β)Y/2

13. Nominal debt and deflation • Ifdebtisdenominated in “dollars”, 1 + rs = (1 + is ) PS/P* • Hererecallthatis ≥ 0  Ifthe shock requires a negative real rate, 1 + rs = PS/P* < 1, e.g. deflation

14. More on Nominal Debt • Ifthedebtisdenominated in dollarsbutthedebtceilingisgiven in real terms, in thepreviousanalysisBhigh/PSmust be lessthanorequal to Dhigh  Deflation can exacerbatetheadjustmentproblem

15. Introducing Production, Etc. • One can introduce an aggregate supply curve in the usual way • See EK • The main point, however, is that aggregate demand can increase with inflation

16. πs AS AD Ys Conventional Macro

17. πs AS AD Ys Bizarre Macro

18. Consecuences • AD curve can have a positive slope • “Paradox of toil” • “Paradox of flexibility” • Inflation is expansionary • Fiscal policy is particularly effective

19. πs AS AD Ys Conventional Macro

20. πs E E’ AS AD AS’ Ys Conventional Impact of a Productivity Increase

21. πs AS AD Ys Bizarre Macro

22. πs E AS E’ AS’ AD Ys The Paradox of Toil

23. πs ASfix ASflex AD Ys Conventional: Price Flexibility Implies a Steeper AS

24. πs Efix ASfix Eflex ASflex AD AD’ Ys Conventional: A fall in demand is less contractionary if prices are more flexible

25. πs ASfix ASflex AD Ys In a bizarre macro world…

26. AD’ πs Efix ASfix Eflex ASflex AD Ys ..the opposite is true: Paradox of Flexibility

27. The Open Economy: Balance Sheets, and Exchange Rates

28. Motivation: Dollarization and the Fixed vs Flexible Rates Debate • Asian Crisis: Exchange Rate depreciations were observed to be contractionary • Explanation: Currency Mismatches • To “work”, one needs financial frictions and balance sheet effects • Intuition: Céspedes, Chang, Velasco

29. The IS y = αii + αxx + αee • Quite conventional • x can be interpreted as any exogenous component of demand

30. LM • Not needed: fixed exchange rates.

31. The BP • The key relation. • Start with investment demand: i = - (ρ + η ) + γ e  Similar to usual assumption.

32. Risk premia η = μ [(1-γ)e + i – n]  Can be derived from more basic models of financial frictions

33. Corporate Balances n = δyy – δee  δedepends on corporate debt and currency mismatches.

34. The BP • Combining two preceding equations, η = μ [(1-γ+ δe)e + i – δyy ] • Inserting in investment demand, one gets the BP relation: (1+μ) i = - ρ + μδyy + [ γ- μ (1-γ+ δe)]e

35. Two types of Economies (1+μ) i = - ρ + μδyy + [ γ - μ (1-γ+ δe)]e • If γ > μ (1-γ+ δe) , we say that the economy is financially robust • Otherwise, we say that it is fragile.

36. i IS BP y

37. i IS’ IS BP y A A fall in Exports

38. i IS’ IS BP A’ y A Without financial frictions, equilibrium would be at A’

39. i IS BP y

40. i IS BP y BP’ A An increase in the world interest rate

41. i IS IS’ BP y Depreciation…

42. i IS IS’ BP’ A BP y Depreciation in robust economy

43. i IS IS’ BP BP’ A y

44. i IS IS’ BP BP’ y A Depreciation in fragile economy

45. i IS IS’ BP y BP’ Depreciation in fragile economy A

46. Some Implications • A strong connection between exchange rates and financial development • Rationale for de-dollarization, leverage limits, and other macro-prudential policies