Capital Flows and Monetary Policy Javier Guillermo Gómez October 2009

Summary Model –Capital inflows and outflows endogenous to shocks to the country risk premium –Equation for evolution of foreign debt Policy experiments: –Floating and fixed exchange rates –High, low debt –Debt denominated in foreign and domestic currencies

Motivation Capital inflows: –Exchange rate appreciates, aggregate demand increases –Inflation decreases (short term), inflation increases (medium term) Capital outflows: –Devaluation, recession, vulnerable balance sheets –Inflation (short term) and disinflation (medium term) Repeated bouts of capital inflows and outflows: –1980’s debt crisis –Crisis of the end of the century –Doc com crisis in 2002 –Global financial crises of 2008 –Consumption and credit booms before these crises

Relation to the literature Vulnerable balance sheets –Krugman (2000). Financial accelerator in the open economy (shocks to the foreign interest rate): –Céspedes, Chang and Velasco (2004) –Gertler, Gilchrist and Natalucci (2001) Constraint on foreign borrowing that binds –Mendoza (2004) –Chari, Kehoe, McGrattan (2005) Effect of sudden stops on output mechanisms not transparent, lack empirical evidence: - Firms borrow in advance to pay imported inputs or wage bill - In cases this produces a shock to total factor productivity

Points of the paper Model of capital outflows and inflows Model of sudden stops and recessions –Recessions depend on interest rate policy Not necessarily on critical balance sheets Capital inflows and outflows obtained with shocks to the country credit risk premium Equation for foreign debt Policy experiments: –Interest rate defenses cause recessions even in financially resilient economies –Behavior of foreign debt not necessarily better (during sudden stops) with a fixed exchange rate –Resilience gained by shifting denomination AND floating the currency

The model Trilema + capital mobility = dilemma (fix or float) Policy interest rate either does not respond to the shock or stabilizes the exchange rate

The model Shocks to the country risk premium Mr. Market: bouts of increase and decrease in risk aversion Capital outflows –Transfer –Trade balance turns positive –NFA improve

The model UIP augmented by the country risk premium Source of volatility: shocks to the country risk premium –Price of risk not contemporaneously related to advanced-country policy rates

The model Two economies domestic and foreign Domestic economy: small and open Foreign economy: approximately closed Each economy produces one good Both goods are tradable Agents in the domestic economy: –Household –Firm –Central bank Assets in the domestic economy: –Domestic bond –Foreign bond denominated in foreign currency –Foreign bond denominated in domestic currency Agent in the foreign economy –Household

The model Domestic economy: nfa < 0 Foreign economy nfa tend to 0 Nominal and real rigidities

The household Solves three problems –Chooses absorption and leisure (here also chooses savings and net foreign assets) –Splits absorption between domestic and foreign goods –Splits domestic goods among a continuum of goods

First order conditions Spread on debt denominated in domestic currency = spread on debt denominated in foreign currency + expected depreciation of exrate Cost of servicing foreign debt denominated in foreign currency = domestic interest rate + unexpected change in exrate Cost of servicing foreign debt denominated in domestic currency = domestic interest rate

The firm Phillips curve Christiano, Eichembaum and Evans (2001): –If firm does not re optimize the price raises by a proportion of lagged inflation

The central bank Follows ad-hoc rule: i = lambda * (spread + i* ) * gap

Foreign household Demands foreign imports = domestic exports

“Closing” the model Spread = 0.9 * spread (-1) - coeff * nfa(-1) + shock to country risk

Budget constraint + Balance sheet => evolution of net worth Budget constraint: absorption = output + ( 1 + r ) * domestic bonds (t-1) - domestic bonds (t) - ( 1 + rstar ) * ( 1 + spread F ) * foreign bonds F (t-1) – foreign bonds F (t) - ( 1 + rstar ) ( 1 + spread H ) foreign bonds H (t-1) – foreign bonds H (t) Balance sheet: domestic bonds + foreign bonds F + foreign bonds H = net worth Law of evolution of net worth: net worth (t) = ( 1 + r + alpha * valuation ) * net worth(t-1) + trade balance (t) net worth (t) = ( 1 + alpha * valuation ) * net worth(t-1) + current account (t) Valuation effect, cost effect, trade balance Lane, Millesi-Ferreti (2005)

Complete model Price block: –CPI identity –Phillips curve (domestically produced goods) –Marginal cost (output gap, exchange rate, technology) –UIP –Policy rule –Spread Flow block: –Aggregate demand –Trade balance –Absorption Stock block: –Net foreign assets

Main flows output = output(+1) – coeff * r + coeff * spread + coeff * rstar trade balance = trade balance(+1) – coeff * r + coeff * spread + coeff * rstar absorption = absorption(+1) – coeff * r

Results

Figure 1. The shock and the policy response

Figure 1 (continued). The shock and the main prices

sudden stops + fixed exchange rate = output drops r ≈ spread > 0 output = output(+1) – coeff * spread trade balance = trade balance(+1) + coeff * spread absorption = absorption(+1) – coeff * spread Drop in output, transfer, drop in absorption

sudden stops + floating exrate = output increases spread > 0, r ≈ 0 output = output(+1) + coeff * spread trade balance = trade balance(+1) + coeff * spread Increase in output and capital outflow

Figure 2. The main flows

Capital inflow + fixed exchange rate = output increases r ≈ spread < 0 output = output(+1) – coeff * spread trade balance = trade balance(+1) + coeff * spread absorption = absorption(+1) – coeff * spread Increase in absorption > increase in output => capital inflow

Capital inflow + floating exrate = output drops spread < 0, r ≈ 0 output = output(+1) + coeff * spread trade balance = trade balance(+1) + coeff * spread Drop in output and capital inflow

Note on calibration –Closed: 0.1 –Opened: 0.5 –Otherwise: 0.3 –Not indebted: -20% –Indebted: -100% –Otherwise: -50%

Capital flows, monetary policy and openness Fixed exrate: r ≈ spread > 0 trade balance = trade balance(+1) + ( cf / sigma ) * spread Flexible exrate: spread > 0, r = 0 trade balance = trade balance(+1) + ( cf + other ) * spread

Figure 3. Trade balance and openness

Calvo, Izquierdo, Talvi (2003): “the required change in exrate is larger the more closed the economy is” Given: size of the transfer Question required depreciation of exrate Answer: depends on openness Here: Given: increase in spread (risk premium shock) Question: effect on trade balance Answer: depends on monetary policy

Figure 4. Factors impacting net worth

Figure 5. Resilience and net foreign assets

Short run: valuation and cost effects have about the same impact on debt Effect of the trade balance on net worth depends on openness and on the length of the shock

Figure 6. Net foreign assets and liability dollarization

Fixed-exchange-rate policy: –Currency denomination “not an issue” Floating-exchange-rate policy: –Currency denomination “matters” Feldstein (2003) “avoiding large amounts of dollar denominated debt is probably the most useful thing a country can do to avoid the serious consequences of a currency fall” Resilience gained not only by shifting the denomination but also by floating the currency

Extension: the financial accelerator The financial cycle and the accelerator, financial booms and busts: –Many assets and balance sheets Here: –Price of one asset (exchange rate) –One balance sheet (household)

Aoki, Proudman, Vlieghé (2004) –PI consumer –Financially constrained consumer By UIP, household indifferent between domestic and foreign finance Premium on foreign borrowing decreases with financial condition of the household Financial condition of the household is nfa Premium decreases with nfa

Figure 7. The accelerator and output in resilient economies

Figure 8. The accelerator and output in fragile economies

Extension: the government Public and private sectors Assumptions: –Fiscal authority committed to solvency –Government follows rule that targets level of debt to GDP –Taxes are lump sum

Budget constraint + balance sheet = law of evolution of net worth (government and private sectors) Valuation effect, cost effect and trade balance (primary balance, private savings) Short term: cost and valuation effects Medium term: primary savings most important (permanent) element in evolution of debt

Fixed exchange rate => transfer born by private sector trade balance = output – absorption private savings = output – taxes – absorption government balance = taxes – expenditure let gvt. expenditure = 0 note: taxes = 0.8 * output + other private savings = trade balance – taxes government balance = taxes sudden stops => private savings increase, government balance decreases Transfer born by private sector

Floating exchange rate => transfer born by both sectors Recall: taxes = 0.8 * output + other output increases => disposable income increases => (absorption constant) private savings increase output increase => taxes increase => government balance increases Transfer born by both sectors

Extension: Flexible price equilibrium More rigorous definitions of –output gap –real interest rate

Conclusions Positive shocks to spread => capital outflow Negative shocks to spread => capital inflow Shocks to spread and capital flows: the same Fixed exchange rate: drop in absorption > drop in output => transfer Flexible exchange rate: increase in output and in the trade balance => transfer Case of Chari, Kehoe, McGrattan (2005): Sudden stops and output increases Only under a floating exchange rate

Exchange rate rigidity => sudden stops and output drops Transparent aggregate demand channel Unlike mechanisms surveyed by Chari, Kehoe and McGrattan (2005) CKM (2005): Sudden stops => increase in net exports and increase in output In this paper: Despite increase in net exports, drop in absorption causes an output drop

From the equilibrium conditions of the model Expression for evolution of nfa Policy experiments –Fixed and floating exchange rate –High and low debt –Debt denominated in foreign and domestic currency

Conclusions of policy experiments Foreign debt not improved by fixed- exchange-rate policy Resilience –Not gained by shifting denomination of debt –Gained by shifting denomination and floating the currency

Limitations Risk structure of interest rates

shock to rstar + rigid exrate = no capital outflow r ≈ rstar > 0 output = output(+1) – coeff * rstar trade balance = trade balance(+1) absorption = absorption(+1) – coeff * rstar => no transfer, recession

shock to rstar + flexible exrate = capital outflow r ≈ 0, rstar > 0 output = output(+1) + coeff * rstar trade balance = trade balance(+1) + coeff * rstar absorption = absorption(+1) => transfer, increase in output