Transcript Introduction: Financial Frictions in Macroeconomics

Financial Frictions, Monetary
Policy, Exchange Rates
Some Basic Issues
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
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
• A modern rendition of Fisher’s argument:
Eggertsson-Krugman
• The basic idea: there is a set of debtconstrained 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
Basic Model
• Two types of agents, with different
discount factors (β(s) = β > β(b) )
• Log utility
• Endowment: (1/2) Y per period
Budget Constraints
Dt(i) = (1+rt-1 )Dt-1 – (Y/2) + Ct(i)
(1+rt) Dt(i) ≤ Dhigh
i = s, b
Steady state
• Impatient agent borrows as much as he can:
Cb = (Y/2) – (r/(1+r)) Dhigh
• Output = consumption:
Y = Cs + Cb
 Cs = (Y/2) + (r/(1+r)) Dhigh
• Patient agent is unconstrained:
(1/Cts) = (1+rt) β Et (1/Ct+1 s)
1+r = 1/β in ss
“Crisis”
• A sudden and permanent reduction in
credit ceiling to Dlow < Dhigh
• In the long run, the impatient agent must
increase consumption:
CbL = (Y/2) – (r/(1+r)) Dlow = (Y/2) – (1-β)Dlow
• In short run, borrower must reduce
consumption to satisfy the new debt
ceiling:
Ds = Dhigh – (Y/2) + Csb
• Key assumption: adjustment takes one
period: Ds =Dlow/(1+rs )
 Csb = Y/2 + Dlow/(1+rs ) - Dhigh
• In long run, patient agent consumes:
CLs = Y/2 + (1-β) Dlow
• In the short run,
CSs = Y – CSb = Y/2 - Dlow/(1+rs ) + Dhigh
• But
CLs = (1+rs)β CSs
Negative interest rates
• Combining,
1 + rs = (Dlow+Y/2)/β(Dhigh+Y/2)
rs is negative if
βDhigh - Dlow > (1- β)Y/2
Nominal debt and deflation
• If debt is denominated in “dollars”,
1 + rs = (1 + is ) PS/P*
• Here recall that is ≥ 0
 If the shock requires a negative real rate,
1 + rs = PS/P* < 1, e.g. deflation
More on Nominal Debt
• If the debt is denominated in dollars but
the debt ceiling is given in real terms, in
the previous analysis Bhigh/PS must be less
than or equal to Dhigh
 Deflation can exacerbate the adjustment
problem
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
πs
AS
AD
Ys
Conventional Macro
πs
AS
AD
Ys
Bizarre Macro
Consecuences
•
•
•
•
•
AD curve can have a positive slope
“Paradox of toil”
“Paradox of flexibility”
Inflation is expansionary
Fiscal policy is particularly effective
πs
AS
AD
Ys
Conventional Macro
πs
E
E’
AS
AS’
AD
Ys
Conventional Impact of a Productivity Increase
πs
AS
AD
Ys
Bizarre Macro
πs
E
AS
E’
AS’
AD
Ys
The Paradox of Toil
πs
ASfix
ASflex
AD
Ys
Conventional: Price Flexibility Implies a Steeper AS
πs
Efix
ASfix
Eflex
ASflex
AD’
AD
Ys
Conventional: A fall in demand is less contractionary
if prices are more flexible
πs
ASfix
ASflex
AD
Ys
In a bizarre macro world…
AD’
πs
Efix
ASfix
Eflex
ASflex
AD
Ys
..the opposite is true: Paradox of Flexibility
The Open Economy: Balance
Sheets, and Exchange Rates
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
The IS
y = αii + αxx + αee
• Quite conventional
• x can be interpreted as any exogenous
component of demand
LM
• Not needed: fixed exchange rates.
The BP
• The key relation.
• Start with investment demand:
i = - (ρ + η ) + γ e
 Similar to usual assumption.
Risk premia
η = μ [(1-γ)e + i – n]
 Can be derived from more basic models
of financial frictions
Corporate Balances
n = δyy – δee
 δe depends on corporate debt and
currency mismatches.
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 + μ δyy + [ γ- μ (1-γ+ δe)]e
Two types of Economies
(1+μ) i = - ρ + μ δyy + [ 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.
i
IS
BP
y
i
IS’
IS
BP
y
A
A fall in Exports
i
IS’
IS
BP
A’
y
A
Without financial frictions,
equilibrium would be at A’
i
IS
BP
y
i
IS
BP
BP’
A
y
An increase in the world interest rate
i
IS
IS’
BP
y
Depreciation…
i
IS
IS’
BP’
A
BP
y
Depreciation in
robust economy
i
IS
IS’
BP
BP’
A
y
i
IS
IS’
BP
BP’
y
A
Depreciation in
fragile economy
i
IS
IS’
BP
y
BP’
A
Depreciation in
fragile economy
Some Implications
• A strong connection between exchange
rates and financial development
• Rationale for de-dollarization, leverage
limits, and other macro-prudential policies