Arnoldshain Seminar XII FCE-UNC 1/21 Neder-Brinatti-Almuzara (2014) Neder, Ángel Enrique Brinatti, Agostina María Almuzara, Martín Ezequiel FCE-UNC Argentina Valencia September 2014 A Model about the Interaction of the Monetary Policy in an Advanced and an Emerging Economy

Motivation FCE-UNC 2/21 Neder-Brinatti-Almuzara (2014) Prices and activity stabilization are not enough for preserving the financial system from fragility. Will there be modifications in the practice of monetary policy in developed and emerging economies, taking into account the international financial crisis? There have been several works dealing with the behavior of CB in advanced economies, but most cases were always aimed at determining the actions of monetary policy only in those economies. A model for both types of economies is proposed trying to shed light on the important role of their interactions, and considering that intermediation is subject to imperfect competition and financial frictions, creating an additional transmission channel for monetary policy.

The Model FCE-UNC 3/21 Neder-Brinatti-Almuzara (2014) DSGE Two open economies (advanced and emerging) Sectors in each economy: Households Firms Banks Government (fiscal and monetary authority) Assumptions: Demands for domestic currency, deposits in domestic currency (in both economies), and foreign currency (in the case of the emerging economy)  MIU framework. Calvo pricing protocol  Phillips Curve for domestic inflation Financial intermediation is subject to imperfect competition and financial frictions. CB sets domestic interest rates according to an “expanded” Taylor Rule.

The Model (end) FCE-UNC 4/21 Neder-Brinatti-Almuzara (2014) Goods, services and assets: Consumption and investment goods Productive services of capital and labor. Deposits (issued by banks) and bonds (issued by government at the advanced economy)  means of saving. Loans and other forms of credit (interbank lending and discount window facilities) Currency (including as foreign currency that issued by the advanced economy and demanded by the emerging one conform a rudiment of a foreign exchange market in the emerging economy) Distinction between economies: Location of financial frictions In the advanced economy  imperfections in the domestic credit market In the emerging economy  frictions in the foreign exchange market

Households FCE-UNC 5/21 Neder-Brinatti-Almuzara (2014) Identical at the two economies, except for the EE hoards foreign currency. Full integration of goods market is assumed. Households consumption is modelled as a Dixit-Stiglitz composite. Households optimize their consumption subject to a budget constraint. Goods market open to international trade without barriers  law of one price  nominal exchange rate.

Households (end) FCE-UNC 6/21 Neder-Brinatti-Almuzara (2014) Optimization process in the EE

Firms FCE-UNC 7/21 Neder-Brinatti-Almuzara (2014) Specification of firms are essentially the same for both the emerging and the advanced economy, except for firms at the advanced economy are exposed to credit risk. Three type of Firms: Capital good producers: who combine depreciated capital (bought to entrepreneurs) and investment goods (bought to retailers) to produce new capital and sell them to entrepreneurs. Entrepreneurs are wholesalers who take bank credit to finance the purchase of capital goods and also demand labor services to produce goods which are demanded by retailers. Retailers: who sell consumption goods to households and investment goods to capital good producers. They costless differentiate goods and set prices according to a Calvo protocol. Every market but investment and consumption good markets are perfectly competitive. That is to say that retailers are the only ones who sell goods under monopolistic competition forces.

Firms FCE-UNC 8/21 Neder-Brinatti-Almuzara (2014) For prices, a similar scheme to that used for consumption goods is used. Firms optimize their investment subject to a given level of expenditure in capital goods, determining a capital price index, which takes into account the expenditure in domestic and imported capital goods. Capital good markets open to international trade without barriers  law of one price  nominal exchange rate.

Firms: Riskyness of Borrowers FCE-UNC 9/21 Neder-Brinatti-Almuzara (2014) Entrepreneurs in the AE face an idiosycratic shock. A variable is defined as a cutoff value: entrepreneurs who receive any value lower than the cutoff are unable to repay their loan in full. The cutoff is defined as the value of that satisfies The aggregate value of the defaulted loans in nominal terms is

Banks: Advanced Economy FCE-UNC 10/21 Neder-Brinatti-Almuzara (2014) Monopolistically competitive banking sector. Banks get funds from Households’ deposits and also take credit in a perfectly competitive interbank market and/or DWF. All financial contracts are of one period length with no risk. Optimization process To maximize their expected profits, banks set nominal interest rates on deposits and loans, the quantity of interbank borrowing and DWF. The net profit function to be maximized is:

Banks: Advanced Economy FCE-UNC 11/21 Neder-Brinatti-Almuzara (2014) Subject to:

Banks: Advanced Economy (end) FCE-UNC 12/21 Neder-Brinatti-Almuzara (2014) Euler Conditions:

Banks: Emerging Economy FCE-UNC 13/21 Neder-Brinatti-Almuzara (2014) Behaviour similar to Banks in an Advanced Economy with the difference that the market for deposits is perfectly competitive. Additionally, they may accumulate government bonds issued both by the Advanced and by Emerging Economies. Optimization process Subject to

Banks: Emerging Economy (end) FCE-UNC 14/21 Neder-Brinatti-Almuzara (2014) Euler Conditions

Monetary Policy: Advanced Economy FCE-UNC 15/21 Neder-Brinatti-Almuzara (2014) The CB sets the reference interest rate according to an extended Taylor Rule. Since the economy may face a liquidity trap, it´s able to use DWF as an alternative policy instrument. So, balance sheet is: DWF rate:Benefits transferred:

Monetary Policy: Emerging Economy FCE-UNC 16/21 Neder-Brinatti-Almuzara (2014) Taylor Rule for deposits interest rate. Doesn´t respond to changes in the interest rate spread: CB may incur in sterilized interventions into the foreign exchange market by varying its stock of foreign bonds in order to compensate fluctuations in the exchange rate. So, balance sheet is: Even though space for exchange rate policy is extremely narrow, a specified rule for int´l reserves constitutes a temptation: Quasifiscal result

Governments FCE-UNC 17/21 Neder-Brinatti-Almuzara (2014) In each economy, they play a passive role  Expenditures and Bonds supply are determined by an autorregressive process, and the budget constraint determines lump-sum taxes (or transferes) that should be collected from (or given to) the household sector. For the Advanced Economy. Similar considerations apply to EE.

Equilibrium Conditions FCE-UNC 18/21 Neder-Brinatti-Almuzara (2014) Real Side Produced goods: Level of expenditure: Financial Side Financial market: Exchange rate market: Bonds market: B of Payments:

Conclusions and avenues for future research FCE-UNC 19/21 Neder-Brinatti-Almuzara (2014) We built a theoretical model which is a contribution in differentiating an AE and an EE and their interaction in monetary policy. Main features of EE: 1.Existence of a hoarding demand for foreign currency. 2.CB intervenes in the exchange rate market with the aim of moderating the exchange rate volatility. Main feature of AE: 1.CB provides liquidity aid to any fundamentally sound bank. 2.Existence of risky firms.

Conclusions and avenues for future research FCE-UNC 20/21 Neder-Brinatti-Almuzara (2014) More work to be done: 1.The incorporation of unconventional monetary policy in the AE which generates spillovers effects on the EE that forces its CB to take decisions that would not be taken in the absence of those effects. 2.Enriching the monetary policy instruments that CB are able to use. For instance, “microprudential tools”. 3.Considering the existence of monetary policy cooperation. 4.Keep calm and carry on.

Arnoldshain Seminar XII FCE-UNC 21/21 Neder-Brinatti-Almuzara (2014) THANK YOU VERY MUCH! A Model about the Interaction of the Monetary Policy in an Advanced and an Emerging Economy Neder, Ángel Enrique Brinatti, Agostina María Almuzara, Martín Ezequiel FCE-UNC Argentina