Financial Heterogeneity and Monetary Union S. Gilchrist 1 R. Schoenle 2 J. Sim 3 sek 3 E. Zakrajˇ Boston University 1 Brandeis University 2 Federal Reserve Board 3 Cambridge University April 19th, 2016
Disclaimer The views expressed should not be interpreted as reflecting the views of the Federal Reserve System or its staff.
Eurozone Crisis (2009–?) Classic balance-of-payment crisis: ◮ The mix of overvalued RERs and cheap credit fueled by economic optimism led to over- and mal-investment. ◮ After the Global Financial Crisis came a sudden stop. Resolution of the crisis: ◮ Realignment of overvalued RERs. ◮ The mix of deflation in the “south” and reflation in the “north.” ◮ Surprisingly hard to achieve—why?
Lessons from the Financial Crisis in the U.S. Gilchrist, Raphael, Sim & Zakrajˇ sek [2015] Empirics: ◮ Firms with strong balance sheets slashed prices. ◮ Firms with weak balance sheets raised prices. Theory: ◮ Develops a GE model that can replicate such patterns. ◮ Emphasizes the interaction between financial market frictions and firms’ pricing decisions in customer markets.
Producer Price Inflation Core producer prices* Industrial production* Percentage points Percentage points 5 5 0 0 -5 -5 -10 -10 Peak: Jan1980 Peak: Jan1980 -15 -15 Peak: Jul1981 Peak: Jul1981 Peak: Jul1990 Peak: Jul1990 Peak: Mar2001 Peak: Mar2001 -20 -20 Peak: Dec2007 Peak: Dec2007 -25 -25 -30 -30 -24 -16 -8 0 8 16 24 -24 -16 -8 0 8 16 24 Months to and from business cycle peaks Months to and from business cycle peaks * Deviations from a linear trend estimated over the 24 months * Deviations from a linear trend estimated over the 24 months preceding the specified recession. preceding the specified recession.
Relative Inflation Financially unconstrained vs constrained firms Percent 4 3-month moving average 2 0 -2 Low liquidity firms -4 High liquidity firms -6 2005 2006 2007 2008 2009 2010 2011 2012 Note: Weighted average monthly inflation relative to industry (2-digit NAICS) inflation.
Inflation Response to Liquidity Coefficient 0.04 Estimate +/- 2 S.E. 0.02 0.00 -0.02 -0.04 -0.06 -0.08 2006 2007 2008 2009 2010 2011 2012
Quantile Response to Liquidity During Crisis 0.2 0.0 -0.2 -0.4 Estimate -0.6 95% confidence interval OLS estimate -0.8 -1.0 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 Quantile
Inflation Response to EBP 12-month PPI inflation and financial conditions By industry-specific indicator of financial constraints 4 Coefficient on EBP (4-digit NAICS) 2 0 -2 -4 p < .10 p >= .10 -6 ^ β = 1.11 |t| = 4.88 -8 R-sq = 0.29 -10 -3.5 -3.0 -2.5 -2.0 -1.5 -1.0 -0.5 0.0 0.5 Median Size-Age Index (4-digit NAICS) Note: Smaller values of the size-age index indicate a smaller likelihood of financial constraints.
Output Response to EBP 8 p < .10 6 p >= .10 ^ β = -1.88 4 |t| = -3.77 R-sq = 0.22 2 Coefficient on EBP 0 -2 -4 -6 -8 -10 -12 -3.5 -3.0 -2.5 -2.0 -1.5 -1.0 -0.5 0.0 0.5 Median Size-Age Index
Inflation and Output Dynamics in the Eurozone 1992-2008 2009-2014 Core GIIPS Core GIIPS Avg. inflation (%) 1.58 3.34 1.22 0.66 Avg. output gap (%) 0.32 0.81 -1.38 -4.88 Panel-version of the NK Phillips curve: π it = 0.449 ( 0.051 ) E t π i , t + 1 + 0.533 ( 0.049 ) π i , t − 1 + 0.104 ( 0.048 ) ( y it − ¯ y it ) + ˆ η i + ˆ ǫ it ◮ AUT, DEU, BEL, FIN, FRA, NLD, GRC, IRL, ITA, ESP, PRT ◮ Annual data: 1970–2014 (unbalanced panel, Obs. = 429) Is lack of deflationary pressures related to financial strains?
Inflation and Output Dynamics in the Eurozone 1992-2008 2009-2014 Core GIIPS Core GIIPS Avg. inflation (%) 1.58 3.34 1.22 0.66 Avg. output gap (%) 0.32 0.81 -1.38 -4.88 Panel-version of the NK Phillips curve: π it = 0.449 ( 0.051 ) E t π i , t + 1 + 0.533 ( 0.049 ) π i , t − 1 + 0.104 ( 0.048 ) ( y it − ¯ y it ) + ˆ η i + ˆ ǫ it ◮ AUT, DEU, BEL, FIN, FRA, NLD, GRC, IRL, ITA, ESP, PRT ◮ Annual data: 1970–2014 (unbalanced panel, Obs. = 429) Is lack of deflationary pressures related to financial strains?
Inflation Dynamics and Financial Strains Sample Period: 2008-2014 3 GIIPS Core 2 Inflation Residuals at t+1 (pct.) 1 0 -1 -2 0.5 1 5 10 20 Sovereign (5-year) CDS Spreads at t (pps., log scale)
Heterogeneity as Propagation Mechanism In this paper, we extend the theoretical framework to two-country GE. Study the consequences of forming a currency union among countries with heterogeneous financial conditions. Price War During periphery’s liquidity crisis, core has a strong incentive to slash markup to gain market share both home and abroad. In contrast, periphery is forced to raise prices to secure cashflow, cannibolizing its own future market share. Self-Reinforcing Crisis Possibility of RERs to appreciate for periphery rather than for core, a feedback loop that reinforces the liquidity crisis of periphery.
Policy Options Fiscal Union: ◮ Trading state-contingent bonds among heterogeneous countries. ◮ Highly beneficial to periphery but requires large transfers from core. ◮ Are the costs of fiscal union bearable by core countries? Fiscal Devaluation: ◮ Certain mixes of fiscal instruments replicate the devaluation. ◮ When can a unilateral fiscal devaluation be beneficial to core? ◮ Depends on the strength of externality created by financial friction.
Preferences Two countries: home ( h = south) and foreign ( f = north) Continuum of households in each country: j ∈ N c ≡ [ 0, 1 ] � c j home goods ( h ) : i , h , t , i ∈ N h ≡ [ 1, 2 ] Two types of goods: c j foreign goods ( f ) : i , f , t , i ∈ N f ≡ [ 2, 3 ] CRRA in habit-adjusted consumption basket x j t : ∞ β s U ( x j t + s , h j ∑ E t t + s ) ; j ∈ [ 0, 1 ] s = 0 ◮ labor ( h ) is immobile
Deep Habits Ravn, Schmitt-Grohe & Uribe [2006] Armington-Ravn-Schmitt-Grohe-Uribe aggregator: � 1 / ( 1 − 1 / ǫ ) � � 1 − 1 / ǫ � � 1 − 1 / η � � 1 − 1 / η dk x j c j i , k , t s θ ∑ t = ω k i , k , t − 1 N k k = h , f ◮ η = elasticity of substitution within a type of goods ◮ ǫ = elasticity of substitution between types of goods ◮ θ > 0 governs the strength of deep habits ◮ 0 < ω k < 1 governs the degree of home bias in consumption Law of motion for deep habits: � c j s i , k , t = ρ s i , k , t − 1 + ( 1 − ρ ) i , k , t dj ; k = h , f N c ◮ “Keeping up with the Joneses” at the good level.
Deep Habits Ravn, Schmitt-Grohe & Uribe [2006] Armington-Ravn-Schmitt-Grohe-Uribe aggregator: � 1 / ( 1 − 1 / ǫ ) � � 1 − 1 / ǫ � � 1 − 1 / η � � 1 − 1 / η dk x j c j i , k , t s θ ∑ t = ω k i , k , t − 1 N k k = h , f ◮ η = elasticity of substitution within a type of goods ◮ ǫ = elasticity of substitution between types of goods ◮ θ > 0 governs the strength of deep habits ◮ 0 < ω k < 1 governs the degree of home bias in consumption Law of motion for deep habits: � c j s i , k , t = ρ s i , k , t − 1 + ( 1 − ρ ) i , k , t dj ; k = h , f N c ◮ “Keeping up with the Joneses” at the good level.
Technology Continuum of monopolistically competitive firms producing variety of differentiated goods of type h and type f . Production function (labor input, fixed operating costs): � A t � α y it = c i , h , t + c ∗ i , h , t = h it − φ ; i ∈ N h ( 0 < α ≤ 1 ) a it ◮ A t = persistent aggregate technology shock ◮ a it = i.i.d. idiosyncratic shock w/ log a it ∼ N ( − 0.5 σ 2 , σ 2 ) ◮ φ = servicing cost of fixed coupon long-term debt Heterogeneity in financial capacity: φ > φ ∗ = 0
Frictions Financial frictions: costly external equity financing ◮ New shares sold at a discount because of asymmetric information e 1 claim raises only e ( 1 − ϕ t ) of funds ◮ “Lemons premium” ϕ t ∼ AR(1) ⇒ financial shock ◮ Makes expected shadow value of internal funds, E a t [ ξ it ] > 1 Nominal rigidities: quadratic cost of adjusting nominal prices Local currency pricing: law of one price does not apply
“Beggar Thy Neighbor” at the Micro Level Deep habits make investment in market share profitable: ◮ Investment takes the form of low markups, which exposes firms to liquidity risk. ◮ Optimal pricing strategy strikes the right balance. Price war: ◮ Liquidity crisis in the South is a good time for firms in the North to steal market share by undercutting competitors’ prices in the south. “Mr. Marchionne and other auto executives accuse Volkswagen of exploiting the crisis to gain market share by offering aggressive discounts. “It’s a bloodbath of pricing and it’s a bloodbath on margins,” he said.” – The New York Times , July 25, 2012
“Beggar Thy Neighbor” at the Micro Level Deep habits make investment in market share profitable: ◮ Investment takes the form of low markups, which exposes firms to liquidity risk. ◮ Optimal pricing strategy strikes the right balance. Price war: ◮ Liquidity crisis in the South is a good time for firms in the North to steal market share by undercutting competitors’ prices in the south. “Mr. Marchionne and other auto executives accuse Volkswagen of exploiting the crisis to gain market share by offering aggressive discounts. “It’s a bloodbath of pricing and it’s a bloodbath on margins,” he said.” – The New York Times , July 25, 2012
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