To Fix, to Float or to Lay Somew here in Betw een? Eduardo J. J. - PowerPoint PPT Presentation

To Fix, to Float or to Lay Somew here in Betw een? Eduardo J. J. Ganapolsky May 2002

Outline ❚ Motivation ❚ What does the literature say? ❚ A different channel ❚ The model ❚ Exercise ❚ Results ❚ Conclusion and extensions

Motivation ❚ In response to some external shocks, countries could react in different ways regarding to the foreign exchange market: ❙ Full intervention, keeping the ER fixed ❙ Not intervene at all, leaving the ER to fully depreciate ❙ Moderate intervention, allowing the ER to depreciate but avoiding sharp depreciations ❚ What are the factors behind those choices? ❙ Costly intervention ❙ Costly depreciations

What does the literature say? ❚ Fear of floating ❙ Empirical: ❘ Low variability of the nominal ER, even in the presence of real or nominal shocks ❘ Low variability stems from deliberate policy actions • High variability of international reserves • High variability of interest rates • High variability of the domestic prices of commodities ❘ Fear of floating is pervasive in emerging markets • Credibility problems (Calvo-Reinhart (2000a)) • Liability dollarization (Calvo-Reinhart (2000b)) • Higher degree of pass through and lower the ability to borrow in own currency (Hausmann-Panizza-Stein (2001))

What does the literature say? ❚ Theoretical : ❙ Lahiri-Végh (2002): ❘ Central banks respond to pressures on their currency with intervention or higher interest rate • Source of fear of floating: ER variability leads to output cost in the presence of nominal wage rigidities • Exogenous intervention cost ❘ Find non-monotonic relationship between nominal ER and the size of the monetary shock • Developing countries are subject to bigger shocks, therefore they are more reluctant to float than developed countries ❘ Either fix or float, do not find dirty floating

What does the literature say? ❚ Theoretical (cont.): ❙ Cavallero-Krishnamurthy (2001): ❘ Inelastic supply of funds during a crisis • Monetary policy has no real effects • ER is very sensitive to monetary policy • Avoid overshooting because of inflationary consequences ❙ Parrado-Velasco (2002): ❘ Short run price rigidity and imperfect competition • Optimal exchange rate policy implies a dirty float

A different channel ❚ Intervention is costly because it makes the government to cut valuable spending ❙ The government finances some expenditure with revenues coming from the return on reserves ❘ Hausmann et al. (2001) find that emerging markets hold high stock of reserves ❙ Tax revenues cannot be increased ❚ Exogenous depreciation cost ❙ Currency mismatch between assets and liabilities ❘ Hausmann et al. (2001): “The original sin” • Find a strong negative link between ER flexibility and liabilities dollarization ❘ Calvo-Reinhart (2000b) ❘ Burnside-Eichenbaum-Rebelo (1999) • Firms and banks borrow extensively from abroad but do not completely hedge exchange rate risk

The model ❚ Small open economy ❚ Perfect capital mobility ❚ One tradable good ❚ LOOP holds ❚ Agents: ❙ Household-cum-firm ❙ Bank ❙ Government ❚ Additional ingredients: ❙ Fixed depreciation cost ❙ Private costs in the banking sector

The model ❚ Household ∫ − β = t ❙ Utility function: log( ) W c e dt t = + − ❙ a m b l Financial wealth: t t t t ❙ Flow constraint: • = + − + − − + τ + Ω − − l a r a y [ F ( r r ) l ] c i m v ( m ) t t t t t t t t t t ❙ 1 Produce goods according to: η = < η < 0 1 y l η t t ❙ Money reduce transaction costs: 1 = − + 2 v ( m ) m m d α t t t

The model ❚ Household ❙ FOCs: 1 1 = λ = c λ c t − − = 1 i i v ' ( m ) = α t t d t m t 2 1 − = − η − 1 l l r r − η = − l 1 t d l ( r r ) t t t

The model ❚ Bank ^ Ω = + − − + − θ l b ❙ Profits : [ F r l ] rb ql sl E t t t t t t where; (1- δ )q is a private cost, 0 <δ≤ 1 l = ❙ Balance-sheet: b b t t − = − r l ❙ FOC: r q s t ^ F = θ ❙ Zero-Profits: E

The model ❚ Government ❙ Flow constraint: • • = + + ε − τ − + − δ h r h m m sl ( 1 ) ql t t t t t t ❙ Intertemporal constraint: • ∫ ∫ − − + + ε = τ + − − δ rt rt r h ( m m ) e dt ( sl ( 1 ) ql ) e dt 0 t t t t ❙ Central Bank balance-sheet: D + = s h m t t E t

The model ❚ Initial steady state ❙ Assume: ❘ ε = µ = 0 ❘ h 0 = 0 ❙ Given that, if the government maximize the household’s welfare, then: s = (1- δ )q ❘ ❙ and: − = δ r l r q ❘ t η − η − − 1 1 r = + δ − η + τ − α − 1 2 c ra ( )( q ) ( ) d ❘ η 0 2

Exercise ❚ Unexpected shock to the money demand(d α < 0) ❙ m t d = h t + D/E t or ❚ What to do? ❚ Choose ∆ h t and ∆ E t such that they maximize the post-shock welfare; or in other words, they minimize the deviation from the previous optimum

Exercise ❚ If fix dh= dm η − η − − 1 1 r − η = + δ − + τ − α + α − c fix 1 2 ra ' ( )( q ds ) ( d )( ) d η 0 2 ❚ If float dh= ds= 0 η − η − − 1 1 r dm − η = + δ + τ − α + α − + θ c float 2 1 ra ' ( )( q ) ( d )( ) d η 0 2 D / E 0 ❚ Trade-off η η − η − − 1 dm − η − η − = δ − − δ − θ fix float 1 1 c c ( )[( q ds ) ( q ) ] η D / E 0

Exercise ❚ The problem is: ∫ − β = t Max W log( c ) e dt t η − η − − 1 1 r ^ = + δ − − η + α + α − + τ − θ 1 2 c ra ' ( )( q ds ) ( d )( ) d E η 0 2 1 − = − δ = δ − − η 1 rdh d [( s q ) l ] ( q ds ) ds − ^ dh dm = E D / E 0

Exercise ❚ Intuition = + ξ − φ L W [ f ( ds ), dh ] [ rdh ( ds )] W f ' W − = f dh φ ' r ❙ The marginal disutility of reducing the subsidy (reduces output) should be compensated for the marginal utility coming from intervention (reduces depreciation costs)

Results ❚ Case 1: ❙ δ = 1; no private costs ❙ θ = 0; no depreciation costs either fix or float ❚ Case 2: ❙ δ > 0 ❙ θ = 0 fully depreciate

Results ❚ Case 3: ❙ δ > 0 ❙ θ > 0 ❘ For θ small enough: fully depreciate (dh= 0) ❘ For bigger θ : intervene (dh< 0) ❙ The interior solution for dh, gives: ❘ dh = g( θ , η , m 0 , δ ) < 0 ❘ g θ < 0; g η > 0; g m0 > 0; g δ < 0

Results ❚ g θ < 0 ❙ The higher the depreciation cost, the higher the intervention ❚ g η > 0 ❙ The lower the bank loans productivity, the higher the intervention ❚ g m0 > 0 ❙ The lower the initial real money stock, the higher the intervention ❚ g δ < 0 ❙ The lower the distortion, the higher the use of the “distortionary tax” to finance the intervention ❚ How about emerging markets?

Conclusion ❚ Introduces a new trade-off between an “output effect” and a “depreciation cost” generated by a financial need ❚ Finds “partial” depreciations ❚ Emerging markets intervene more than developed countries ❚ It is key the absence of non-distortionary taxes: the government can raise resources only through “distortionary” taxation ❙ Focused on a particular case: distortion in the financial sector ❙ Trade-off between helping the financial sector and keeping the value of the currency

Extensions ❚ Introduces inflation tax as an alternative source of funds ❚ Model explicitly the depreciation cost coming from the currency mismatch ❚ Incorporate some appreciation cost (traditional competitiveness story) to obtain intervention on both ups and downs in the exchange rate ❚ Generalize the channel as a “fiscal” explanation of the fear of floating phenomenon