The growth of emerging economies and global macroeconomic stability - PowerPoint PPT Presentation

The growth of emerging economies and global macroeconomic stability Vincenzo Quadrini University of Southern California June 21, 2015

GDP of Emerging Countries Relative to Industrialized Countries 1.2 At Parchasing Power Parity 1 At Nominal Exchange Rates 0.8 0.6 0.4 0.2 0 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013

Net Foreign Position in Debt and Reserves ( Percent of GDP ) 0.3 Emerging Countries 0.2 Industrialized Countries 0.1 0.0 ‐ 0.1 ‐ 0.2 ‐ 0.3 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

QUESTION How does the growth of emerging economies affect the financial and macroeconomic stability of both emerging and industrialized countries? 3

ADDRESSING THE QUESTION 1. I develop a two-country model where global banks play a central role. 2. Emerging countries have a greater demand for financial assets. 3. The model generates financial crises induced by self-fulfilling expectations about the liquidity of the banking sector. 4. I then use the model to study how the growth of Emerging Economies affects macroeconomic stability. 4

PREVIEW OF RESULTS • The increased size of emerging countries increases the world demand for liquid assets (bank liabilities in the model). • This reduces the interest rate paid by banks and creates an incentive for banks to leverage. • The higher leverage increases financial fragility: higher probability of a crisis and/or the macroeconomic consequences of a crisis. 5

THREE SECTORS MODEL 1. Entrepreneurial sector 2. Worker sector 3. Financial intermediation sector 6

1. Entrepreneurial sector t =0 β t ln( c i � ∞ • Continuum of entrepreneurs with utility E 0 t ) • Technology F ( z i t , h i t ) = z i t h i t h i t = Input of labor z i t = Idiosyncratic shock observed after choosing h i t . • They can buy bonds b i t +1 . The budget constraint is t + b i t +1 c i = ( z i t − w t ) h i t + b i t ≡ a i t R b t 7

Optimal entrepreneur’s policy h i φ ( w t ) b i = t t c i (1 − β ) a i = t t b i t +1 βa i = t R b t � � z − w t Where φ t satisfies E z = 0 . 1+( z − w t ) φ t 8

Aggregate demand of labor � b i H t = φ ( w t ) t i ���� Financial wealth ✻ H t ✲ w t 9

Aggregate demand of labor � b i H t = φ ( w t ) t i ���� Financial wealth ✻ H t ✲ w t 10

2. Worker sector � � h 1+ ν � ∞ t =0 β t • Continuum of workers with utility E 0 c t − α ¯ z t t 1+ ν • They hold a non-reproducible asset in fixed supply K , traded at price p t . Each unit produces χ ¯ z t units of consumption goods. • They can borrow subject to the collateral constraint l t +1 ≤ η E t p t +1 k t +1 R l t • Budget constraint c t + l t + ( k t +1 − k t ) p t = l t +1 + w t h t + χ ¯ z t k t R l t 11

First order conditions for workers αh ν t = w t 1 = βR l t (1 + µ t ) � � p t = β E t χ + (1 + ηµ t ) p t +1 12

Aggregate supply of labor � 1 � w t ν H t = α ✻ H t ✲ w t 13

EQUILIBRIUM WITHOUT INTERMEDIATION (Borrowing and lending is direct) 14

LABOR MARKET EQUILIBRIUM ✻ Labor supply H t � 1 � wt H S ν t = α Labor demand H D = φ ( w t ) B t t ✲ w t 15

LABOR MARKET EQUILIBRIUM (Lower stock of bank liabilities) ✻ H t Labor supply � 1 � wt H S ν t = α Labor demand H D = φ ( w t ) B t t ✲ w t 16

INTRODUCING THE INTERMEDIATION SECTOR 17

Schematic overview of the economy Net savers Net borrowers Financial (Entrepreneurs/ (Workers) Intermediaries producers) Consumption Consumption Hiring Labor supply

3. Intermediation sector • Banks start with liabilities b t and loans l t . � � • The liquidation value of bank assets is ξ t l t , with ξ t ∈ ξ, 1 . • Banks renegotiate if liabilities exceed the liquidation value of assets, � if b t ≤ ξ t l t b t , ˜ b t ( b t , l t ) = if b t > ξ t l t ξ t l t • There is an intermediation cost that rises with leverage. � b t +1 � ϕ t ( b t +1 , l t +1 ) = ϕ ˜ − ξ b t +1 l t +1 19

LOW LEVERAGE (No default) ✻ ξ l t l t b t 20

HIGH LEVERAGE (Possibility of default) ✻ ξ l t l t b t 21

Bank’s problem � � V t ( b t , l t ) = max d t + βE t V t +1 ( b t +1 , l t +1 ) d t ,b t +1 ,l t +1 subject to + d t = l t + E t ˜ ϕ t ( b t +1 , l t +1 ) + l t +1 b t +1 ( b t +1 , l t +1 ) ˜ b t ( b t , l t ) + ˜ b R t R t First order conditions � � �� b t +1 1 t = β 1 + Φ R b l t +1 � � �� b t +1 1 t = β 1 + Ψ R l l t +1 22

Two-countries: The growth of emerging economies and global imbalance 23

Cross-country heterogeneity 1. Differences in size: • Productivity, ¯ z j 2. Differences in financial market characteristics: • Volatility of the idiosyncratic shock, σ j • Borrowing limit, η j 24

SIMULATION EXERCISE • Country 1: Industrialized economies . Country 2: Emerging economies . • Relative productivity ¯ z 2 z 1 changes over the period 1991-2013. ¯ • Model simulation repeated 1,000 times. In each simulation: – Same sequence ¯ z 2 z 1 ; ¯ – Different sequences of random draws ξ . 25

CALIBRATION (Based on early 1990s data) • Quarterly model with β = 0 . 985 . • Working dis-utility parameter α j to have average labor equal to average employment over population. • Output from fixed asset χ to match share of housing services in GDP χ Housing service share = H j,t + χ • Collateral parameter η j to generate private credit to GDP in each country. • Volatility of idiosyncratic shock σ 1 = [0 . 7 , 1 . 3] , σ 2 = [0 . 4 , 1 . 6] . 26

CALIBRATION (Based on early 1990s data) • Low realization of shock ξ = 0 . 85 . • Intermediation cost  0 , if ω t +1 ≤ ξ  ϕ ( ω t +1 ) = τ + .  ( ω t +1 − ξ ) 2 , if ω t +1 > ξ Parameter τ chosen to target the share of finance in GDP. 27

Calibration of relative productivity (Based on 1991-2013 data) � H 2 ,t + χ � GDP 2 ,t z 2 ,t ¯ = . ¯ H 1 ,t + χ GDP 1 ,t z 1 ,t 28

REPEATED SIMULATIONS

REPEATED SIMULATIONS

FOR A PARTICULAR SEQUENCE OF SHOCKS • From 1991 to third quarter of 2008 the realization of the shock is HIGH. • In the fourth quarter of 2008 the realization of the sunspot shock is LOW. • Afterwards, the realization of the sunspot shock is HIGH. 32

SPECIAL SIMULATION

SPECIAL SIMULATION

CONCLUSION • Cheap funding for banks creates an incentive to leverage. • More leverage exposes the banking sector to crises. • The growth of emerging economies pushes the globalized economy in this direction raising financial and macroeconomic instability. 35