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Essays on exchange rate policies and monetary integration

Ibrahima Sangare

To cite this version:

Ibrahima Sangare. Essays on exchange rate policies and monetary integration. Economics and Fi- nance. Université de Bordeaux, 2015. English. �NNT : 2015BORD0381�. �tel-01297054�

THÈSEPRÉSENTÉE POUROBTENIRLEGRADEDE

DOCTEUR DE

L ’UNIVERSITÉ DE BORDEAUX

ÉCOLEDOCTORALEENTREPRISE,ÉCONOMIE,SOCIÉTÉ(EDN°42) SPÉCIALITÉ:SCIENCESÉCONOMIQUES

ParIbrah imaSANGARE

ESSAYS ONEXCHANGE RATE POLICIES AND MONETARYINTEGRATION

Sousladirectionde:

Michel DUPUY,ProfesseurdesUniversités etCristina BADARAU, MaîtredeConférences,HDR

Soutenuele14Décembre2015 Membresdujury:

MmeEleniILIOPULOS

ProfesseurdesUniversités,Universitéd’Evry-Vald’Esonne M. Gilles DUFRÉNOT

ProfesseurdesUniversités,Aix-MarseilleSchoolofEconomics,Rapporteur Mme Cécile COUHARDE

ProfesseurdesUniversités,UniversitéParisOuest-NanterrelaDéfense,Rapporteur M.Fabrice COLLARD

ProfessorofEconomics,UniversityofBern M. Michel DUPUY

ProfesseurdesUniversités,UniversitédeBordeaux Mme Cristina BADARAU

MaîtredeConférences,HDR,UniversitédeBordeaux

Remerc iements

Toute mareconnaissanceet maprofondegratitudeà mesdirecteurs, M. MichelDupuyet MmeCristinaBadarau,pourlaconfiancequ’ils m’ontaccordéeen meproposantcettethèse financée.Leurencadrementetsoutienrégulier m’ontétéd’uneutilitéinestimabletoutau longdecettethèse.Jeleursuisredevablepourlarigueurscientifiqueaveclaquelleils m’ont accompagnédans mestravauxetpourleurpréoccupationpour monavenirprofessionnelen tantquedoctorantsousleurresponsabilité.

Jeremercievivement M. Gilles Dufrénotet MmeCécileCouhardepouravoiracceptéde rapportersurcettethèse,ainsique MmeEleniIliopuloset M.FabriceCollardpourl’intérêt qu’ilsontaccordéausujetdecettethèseenacceptantd’être membresdujury.

Mesremerciementsprofondsà MmeFlorence Huart,pourtoussesconseilsetremarques dontj’aieulachancedebénéficieràtraverslacollaborationetlesenrichissantséchangesque nousavonseusensembleaucours mathèse.

Ilmeseradifficiled’oublierceuxquim’ontrendul’environnementprofessionnelsiconvivial àtraversleschaleureusesrelationsquenousavonseuesànoueretnoséchangesaussibiensur l’économiequesurlavieengénéral.Jeciteraisparlà:Thomas,LouisDupuy,LouisRaffestin, MarineetViola.

J’adresseungrand mercià Viola,Louis Dupuy, Rhody-AnnetJeannepourlarelecturede certainespartiesdecetravail.Jen’oubliepaslepersonneladministratifduLAREFI,Cyril et Christelpourleurdisponibilité,ainsiquetouslesparticipantsauxdifférentsséminaires internesdulaboratoire,danslesquelsj’aipuprésentercertainsélémentsdecetravail,pour leurscommentaires.

Ungrandmerciàtousmesamisquiontrendumavieextra-universitaireagréable.Jepense àLouisPatetsonépouse,Solo,Kabinetetsonépouse,Cissé,Savané,Zabac.

Enfin,mespenséess’envolentversmonpèreetmamèrequiauraientaimésêtrelàaujourd’hui mevoirauboutd’uncheminlongetrugueux maisqui malheureusementnousontquittésici basdurantcettethèse.Jelesremercieaujourd’huipouravoircruenmoi,pourleurpatienceet leursbénédictionssanslesquellesjeneseraispaslàaujourd’hui.Jeleurensuisgrédufonddu cœuretespèrequ’ilssontfiersde moidelà-haut.

Mesaffectueuxremerciementsà monépouse Mariamepouravoirétélàpour moientantque soutienetconseillèrefaceauxépreuvesdelaviedontcellesdecettethèse,etpour m’avoir supportéenparticulierlorsdelarédactionfinaledecetravail.

Atoutescespersonnesquin’ontpasétécitéesnommément,jeleurdis merci.

A monpèreet ma mère

Résumé

Cettethèseétudielechoixdesrégimesdechangedansdeuxcontexteséconomiquesparticu- liers.Ellecomposéedequatre(4)essaisprésentésendeuxparties.

Ayantàl’espritlasituationdespaysasiatiques,lapremièrepartie(Chapitres1et2)considère lecasdespetitspaysdontlesdettessontlibelléesenmonnaiesétrangères(doncpotentiellement vulnérablesauxchocsextérieurs)etceluid’unerégionconstituéedetelspetitspayslorsqu’il existeunesimilitudedanslacompositiondespaniersde monnaiesdéfinissantleurstauxde changeeffectifs.

Partantdel’expériencedescrisesrécentesauniveau mondial,ladeuxièmepartiedelathèse (Chapitres3et4)sepenchesurlaconsidérationdesdifférentsrégimesdechangedansle contexte monétairedetrappeàliquiditécomparativementàunenvironnement monétairetra- ditionnel.

Ensebasantsurune modélisationthéoriquedetype DSGE,l’économétriebayésienneet desdonnéesdepanel,lathèseutiliseprincipalementl’analysedesfonctionsderéponses,de bien-êtreetdedésalignementsmonétairescommecritèresdecomparaisondeplusieursrégimes monétairesalternatifs.

Lepremierchapitrecomparelesperformanceséconomiquesetentermesdebien-êtredes quatreregimes(leflottementpur,leflottementdirigé,lazonecibleetlechangefixe)àl’aide d’unmodèled’équilibregénéralstochastiquedynamique(DSGE)depetiteséconomiesouvertes quiintègrelephénomèned’endettementen monnaiesétrangères.Enutilisantl’économétrie bayésienne,le modèleestestimésurlabasedesdonnéesdecinq(5)paysd’AsieduSud- Est, membresfondateursdel’Associationdesnationsdel’AsieduSud-est(ASEAN). Nous trouvonsquepourdespetitspayscommeceuxdel’AsieduSud-Est,lechangeflexiblesemble êtrelemeilleurrégime,suividesrégimesintermédiairesetduchangefixe.Cependant,ledegré d’ouverturedespaysjoueunrôleimportantdansceclassement.

Ledeuxièmeessaiétudieàl’aided’unmodèlethéoriquemulti-paysdetypeDSGE,lesimpli- cationsdelapolitiquedeciblagedutauxdechangeeffectifentermesd’intégration monétaire dansunerégioncaractériséeparunesimilitudedanslacompositiondespaniersde monnaies définissantlestauxdechangeeffectifsdespays.Auniveaurégional,ilestmontréquelesalloca- tionssouslesrégimesd’union monétaireetdeciblagedutauxdechangeeffectifsontproches.

Deplus,leciblageeffectifconduitàunestabilitédestauxdechangebilatérauxdelarégion, unesortedefixitédestauxdechangequiressembleraitàunezone monétairedefacto.

Letroisièmeessaitraitelechoixdurégimedechangeappropriéàunenvironnementécono- miquedetrappeàliquidité.Untelenvironnementestcrééparunchocasymétriquedéflation- nistequicontraintletauxd’intérêtnominalàsonniveauplancherdezéro.Danscecasondit quelacontraintedenonnégativitédutauxd’intérêtestactive(«ZeroLowerBound(ZLB) constraint»enanglais).Cetessaiutiliseplusieursversionsd’un modèle DSGEàdeuxpays etdeuxsecteurs.Noustrouvonsque,contrairementàlacroyancecommunelorsdelacrisede lazoneeuro,l’union monétaireestplusperformantequelespolitiquesnationalesdechange flexible.Seuleuneinterventionsurletauxdechangenominalpourraitpermettreaurégimede changeindépendantdedominerl’union monétaire.

Ledernieressaidecettethèseétudiethéoriquement(àl’aided’un modèle DSGEàdeux paysetdeuxsecteurs)etempiriquement(àl’aidederécentdéveloppementsdel’économétriedes donnéesdepanel)leseffetsdelatrappeàliquiditésurl’ampleurdesdésalignementsmonétaires etproposeleursimplicationsentermesd’intégration monétaireetdechoixdesrégimesde change.NosrésultatssuggèrentquelacontrainteZLBtendàréduireledésalignementmonétaire dansuneunionmonétairecomparativementauxpolitiquesnationalesdeflottement.Celaplaide enfaveurdurenforcementdel’intégration monétaireauseind’uneuniondurantlapériodede trappeàliquidité.

Finalementcettethèsefournitunegrilled’analysedespolitiquesdechangedansdescontextes particuliersjusquelàignorésparlalittératuredanscedomaine,nonseulementauxdécideurs despetitspaysémergentsouendéveloppementquiseraientàlarecherched’unrégimede changeappropriéàleursituation maisaussiàceuxdespaysavancésdelazoneeuroetceux disposantdeleurindépendance monétaire.

iv

Abstract

Thisthesisinvestigatesthechoiceofexchangerateregimesintwospecificeconomiccontexts. Itconsistsoffour(4)essayspresentedinformoftwoparts.

First,basedontheexperienceofsoutheastAsiancountries,thefirstpartofthiswork(Chapters 1and2)considersthecaseofsmallopeneconomieswithforeign-currencydenominateddebt andthatofaregion wherethereisasimilarityamongtrade-weightedcurrencybasketsof countrieswhich managetheireffectiveexchangerates.

Afterwards,inthelightoftheexperienceoftherecentcrises,thesecondpartofthethesis (Chapters3and4)focusesonthestudyofexchangerateregimesandmonetaryintegrationin aliquiditytrapenvironment(i.e.zerolowerboundcontext)relativeto“tranquil”times.

Basedondynamicstochasticgeneralequilibrium(DSGE) modelsandBayesianandPanel dataeconometrics,thethesis mainlyusestheanalysesofimpulseresponses,welfareandcur- rency misalignmentsascomparisoncriteriaamongalternativecurrencyregimes.

Thekeylessonsfromthisworkaresummarizedasfollows.Forsmallopeneconomiesheavily indebtedinforeigncurrency,likethoseofSoutheast Asia,theflexibleexchangeisthebest regime,followedbyintermediateandfixedexchangerateregimes. However,thedegreeoftrade opennessplaysaroleinestablishingarankamongtheregimes. Attheregionallevel,itis shownthateconomicallocationsunderanexchangeratetargeting(managedfloat)regimeare closetothoseunderamonetaryunion.Furthermore,theexchangeratetargetingregimeleads toastabilityofintra-regionalbilateralexchangerates, whichisasortoffixityofexchange ratessimilartoa“defactocurrencyarea”.

Inthecontextofaliquiditytrap,wefindthat,contrarytocommonbeliefduringtheEuroarea crisis,thecurrencyunionwelfaredominatestheindependent(national)floatingregime. Only acentralbankinterventionintheformofa managedfloatpolicycouldallowtheindependent floatingtooutperformthe monetaryunion.

Throughboththeempiricalandtheoreticalanalysesoftheliquiditytrapeffectsoncurrency misalignments,itisshownthattheZLBconstrainttendstoreducecurrency misalignments comparedwiththeindependentfloatingpolicy.Thissuggestsareinforcementofthemonetary integrationwithina monetaryunionduringtheliquiditytrap.

Summary

Generalintroduction 1

PARTI Exchangerateregimesand monetaryintegrationforsmall open

economiesindebtedinforeigncurrency 9

1 Externalshocks,exchangerateregimesandforeign-currencyindebtedness 10

1.1 Introduction... 11

1.2 The model... 15

1.3 Calibration,estimationandoptimal monetaryrules... 28

1.4 Impulseresponses,welfareanalysisandexchangeratepolicyimplications.... 34

1.5 Conclusions... 44

AppendixA... 46

2 Effectiveexchangeratetargetingand monetaryintegration 83 2.1 Introduction... 84

2.2 Atwoopen-regionDSGE model... 88

2.3 Calibrationofthe modelandresults...101

2.4 Conclusions...114

AppendixB...115

PARTIIExchangerateregimesand monetaryintegrationinaliquiditytrap 120 3 Exchangerateregimesinaliquiditytrap 121 3.1 Introduction...122

3.2 Atwo-sectortwo-country model...127

3.3 Calibration ...133

3.4 Resultsforthebaseline model...135

Summary SUMMARY

3.5 Robustnessandextensions ...139

3.6 Welfareanalysis ...152

3.7 Conclusionsandpolicyimplications...156

AppendixC...159

4 Currency misalignments,exchangerateregimesandliquiditytrap 168 4.1 Introduction...169

4.2 Empiricalinvestigation...172

4.3 The model...188

4.4 Concludingremarksandpolicyimplications...207

AppendixD...209

Generalconclusion 218 References...221

Listof Tables 234

ListofFigures 236

Genera lintroduct ion

“Nosinglecurrencyregimeisrightforallcountriesoratalltimes”,Frankel(1999). Theappropriatechoiceofexchangerateregimeisattheheartofexchangeratepolicies. The abovequotationfromFrankel(1999)justifiestherecurrenceofthedebateonthisissueinin- ternational macroeconomicsanditscontroversialaspect. Choosinga monetaryregimeisone ofthe mostimportantpoliticalandeconomicdecisionstobetakenbypolicy makers.

Despitethefactthatpracticesofexchangeratepoliciesdifferedacrosscountriesandovertime, anhistoricaloverviewidentifiessometrendsinthechoiceof monetaryregimesthroughout theworld. AfterearlyexperimentswithfloatingregimesfollowingthecollapseoftheBretton Woodssystem,onecanobserveasurgeinthepopularityoffixedexchangerateregimesinthe 1980sandearly1990s.Thisisduetotheirpresumedbettertrackrecordforinflationstabiliza- tion. However,thecurrencycrisesexperiencedinthe1990sandearly2000s(in Mexico(1994), SoutheastAsia(1997),Brazil(1998), Argentina(2002)amongothers)endedtheenthusiasm forfixedexchangerateregimes(inparticular,pegsandcurrencyboards).Inrecentyearsthere hasbeenagrowingpracticeof managedexchangerates¹.

Atthesametime,therehasbeenasignificantdevelopmentofempiricalandtheoreticalre- searchesonthistopicinordertounderstandthecausesandconsequencesofexchangerate regimeselection. FollowingLevy-Yeyatietal.(2010),thisbodyofliteraturesuggeststhree maincompetingapproachestoexplainthechoiceofexchangerateregimes:thetheoryof optimalcurrencyarea,thefinancialandpoliticalapproaches.

1) Theoptimalcurrencyarea(henceforth OCA)theory,presagedbyFriedman (1953)anddevelopedby Mundell(1961), McKinnon(1963)and Kenen(1969),explainsthe choiceofexchangerateregimebythecountry’scharacteristicssuchastradelinkage,country’s size,tradeopenness,degreeoflabourmobilityandthenatureofshocksthathittheeconomy². Indeed,inhisprecursorywork“Thecaseforflexibleexchangerates”,Friedman(1953)argued thattheflexibleexchangeratesarepreferablewhenpricesandwagesaresticky,sincetheyallow relativepricesofhomeandforeigngoodstoadjustfasterinordertoabsorbadverse(real)shocks. Mundell(1961)andFleming(1962)havetakenoveranddevelopedFriedman’scaseforflexible

1.SeeIMF(2014).

2.SeeDellasandTavlas(2009)fora moredetaileddiscussionontheOCAtheory.

Generalintroduction

exchangerates,buildingwhatwillhenceforthbecalledintheliteraturethetraditionalargument oftheexpenditureswitchingeffect(Mundell-FlemingframeworkorIS-LM-BPmodel).Indeed, relativecurrencydepreciationinacountrywithaninitialcurrentaccountdeficitwouldlead toaswitchindemandtowardsitsdomesticallyproducedgoodsleadingtoariseinitstrade balance. Thespeedofthisadjustmentinrelativedemandshighlightstheimportantroleof exchangerateflexibilityinasticky-priceworld.

Recently,inaseminalarticle, DevereuxandEngel(2003)castdoubtonthecaseforflexible exchangerates,emphasizingthatalowexchangeratepass-throughweakenstheexpenditure effectandthereforelimitstheeffectivenessoffloatingregimes. Morespecifically,importsare supposedtobepricedinthecurrencyoftheproducer(producercurrencypricing-PCP)inthe conventional Mundell-Flemingframeworkandthelawofonepriceholdsfortradablegoods. Thereforethepass-throughofexchangeratetoimportpricesisassumedtobecompleteand immediate. Theseauthorshaveconsideredthat,whenimportsarepricedinhomecurrencyof buyers(localcurrencypricing-LCP)-i.e.anincompleteexchangeratepass-through-aflexible exchangeregimeispowerlesstoinsulatetheeconomyfromadverseshocks.

Since,therehasbeenanumberofargumentsagainstthispoint,restoringfaithinexchange rateflexibility.Forinstance,DuarteandObstfeld(2008)showthat,despiteLCP,ifnon-traded consumptiongoodsareintroducedinthe model,flexibleexchangeratesperformbetterthan fixedones. Theneedforexchangerateflexibilityinsuchacasecomesfromtherisksharing condition.Itarisesbecauseofasymmetricresponsesofdomesticandforeignconsumptionto realshocks. DevereuxandEngel(2007)findthatoptimalexchangerateflexibilitydepends onthetrade-offbetweenexpenditureswitchingandrisksharing.Sutherland(2006)highlights theroleoftheelasticityofsubstitutionbetweenhomeandforeigngoodsindeterminingthe strengthoftheexpenditureswitchingeffect. Furthermore,Sutherland(2005)showsthatthe optimalexchangeratevariabilitydependsonsomeparameterssuchasthedegreeofexchange ratepass-through,thesizeandopennessoftheeconomyamongothers.

Allinall,theinfluentialcontributionsintheOCAtheoryremainthetriadofpaperswrittenby Mundell, McKinnonandKenen.Theyidentifytheconditionswhich,ifsatisfied,reducethecase forindependentflexibleexchangeratesandoffercriteriaforcurrencyareaoptimality:labour mobility, wageandpriceflexibilityandsymmetryofshockfrom Mundell(1961),country’s size,degreeofopennessandtradeintegrationasstatedby McKinnon(1963),fiscalintegration,

Generalintroduction

productdiversificationandthesimilarityofeconomicstructuresamongcountriesintroduced byKenen(1969).

Anothertakeon OCAtheoryisnottofocusontheflexibilityofnominalexchangerates, butratheronthedeviationoftherealexchangeratefromalevelconsistentwitheconomic fundamentals(currency misalignments). Accordingtothisview,anoptimalexchangerate regimewouldbethatunderwhichtherealexchangerateistheleastmisaligned,i.e.wouldallow anoptimalallocationofdemand, maximizingeconomicperformance. Currency misalignments beingrelatedtothestandardcriteriaofOCAtheory,theycanbeconsideredinthissenseas anoverallindicatoroftheviabilityofacurrencyunion(Coulibalyand Gnimassoun(2013)). Inthisrespect,Couhardeetal.(2013)defineasustainablecurrencyareaasamonetaryunion inwhichcurrency misalignmentsarenotpersistentlyhigh. CoudertandCouharde(2009)and Holtemöllerand Mallick(2013)findthatfixedexchangerateregimesgenerate morecurrency misalignmentthanthefloatingones.

2) Thefinancialapproachisbasedontheconsequencesofinternationalfinancialinte- gration. Twostreamsofliteraturearebasedonthisapproach. First,theimpossibletrinity literatureaccordingtowhichfinancialintegrationtendstoencouragefloatingregimesamong industrializedcountries. Second,theviewbasedonthecurrencydenominationofexternal liabilities,whichrecommendsfixedexchangeratesforcountriesindebtedinforeigncurrency, suchasemerginganddevelopingcountries.

Introducedby Mundell(1963)andFleming(1962),theimpossibletrinityindicatesthatpolicy makersareinterestedinthreegoalsand mustgiveuponeofthem:exchangeratestability, monetaryindependenceandfinancial marketintegration(freecapital mobility).In morede- tails:

-Exchangeratestability(fixedexchangerates)canbecombinedwithfreecapitalmobilitybut monetaryindependencehastobegivenup;

-Flexibleexchangeratesallowsacombinationofmonetaryindependenceandfreecapitalmo- bility,whileexchangeratestabilityisforfeited;

-Capitalcontrol(absenceoffinancialintegration)enableacombinationofexchangeratessta- bilityand monetaryindependence.

Frankel(1999)emphasizesthattheprincipleoftheimpossibletrinityistheunderlyinglogicin

3

Generalintroduction

thebipolarviewofthechoiceofexchangerateregime³.

Usinganotherangle,someworks(Cespedesetal.(2004),ChoiandCook(2004),Cook(2004), Devereuxetal.(2006), Gertleretal.(2007))havelinkedthechoiceofexchangerateregimes tothephenomenonoftheforeign-currencydenominateddebt. Thischaracterizes mostofthe non-industrializedcountries. Foreign-currencydenominateddebtisissuedwhencountriesare unabletoborrowintheirowncurrencyandisreferredinsomecontextsasthe“originalsin”⁴. Theseworksdiscussedthestabilizationpropertiesofexchangerateregimes,consideringafi- nancialacceleratoràla Bernankeetal.(1999). Theyconsideranendogenousexternalrisk premiumcombinedwithforeign-currencydenominatedliabilities. Theintuitionhereisthat financialimperfectionslinkedtotheendogenousriskpremium magnifytheshockeffects. Due totheforeigncurrencydebt,exchangeratedepreciationmayworsenfirms’balancesheets.This balancesheeteffect, magnifiedbyfinancialimperfections,causesacontractionofinvestment andthereforecoulddepressoutput. Fixedexchangerates maythenbepreferredtofloating onesin(emerging)countrieswhicharestronglyindebtedinforeigncurrency. Anon-negligible partofthecrisisliterature(Aghionetal.(2001),EichengreenandHausmann(1999),Krugman (1999),CalvoandReinhart(2000))identifythesebalancesheeteffectsasamajorfactorinthe sharpcontractionofoutputduringthe1990scurrencycrisesinemerging marketeconomies. Thisjustifiesthesubsequent“fearoffloating” makingpegging moreattractiveinthesecoun- tries⁵.

Yet,thereisnoconsensusintheliteratureonthesuperiorityoffixedexchangerateswhenthe balancesheeteffectispresent.Indeed,whileChoiandCook(2004)andElekdagandTchakarov (2007)findthatfixedexchangerateregimesdominateflexibleones,Cespedesetal.(2004), Devereuxetal.(2006)and Gertleretal.(2007)showthat,eveninthepresenceofforeign currencydebt,thetraditional Mundel-Flemingprescriptionpromotingtheflexibleexchange rateregimesprevails.

3)Thepoliticalviewlinksthechoiceofexchangerateregimetothequalityofinstitutions andpolicy makersintheconsideredcountries. Inthisapproach,thecredibilityofpolicy makersandinstitutionsleadstotheadoptionofsomecurrencyregimesagainstothers. Hence, governmentswithapreferenceforlowinflationbutfacedtoalowinstitutionalquality may

3. Thebipolarviewischaracterizedbytherejectionofintermediateregimesinfavourofcornerssolutions: floatingandfixedexchangerateregimes.

4.SeeEichengreenandHausmann(1999).

5.SeeCalvoandReinhart(2002)whoanalyzedthe“fearoffloating”syndromeforemerging markets.

Generalintroduction

adoptapeginordertocontrolinflationaryexpectations⁶. Countrieswithweakinstitutions (morevulnerabletopressuresfrominterestgroups) maybepronetorelyonfixedexchange rateregimesasasolutiontothecommitmentproblem. Butthisargumentconflictswiththe sustainabilityissue,whereaweakgovernmentmoreoftensubjectedtolargerdeficitsandwitha lesserabilitytoreducethem,isunabletomakethefixedexchangerateregimesustainable⁷.It thusfollowsthattheliteratureprovidesunclearanswerregardingtherelationbetweenpolitical conditionsandexchangerateregimes. Forexample,Levy-Yeyatietal.(2010)findthatthe choiceofapegisnegativelycorrelatedwithinstitutionalquality,butpositivelycorrelatedwith politicalstrength,highlightingthesustainabilityproblem.

Thisthesisfocusesonthefirsttwoapproachesandaimstoinvestigateanumberofshort- comingsinthesecontributions. Althoughtheseminalworksof MundellandFleminginthe 1960sarenotbasedonmicro-foundedmodelsandperformedinpartialequilibrium,mostofthe subsequentstudiesanalysingthechoiceof monetaryregimesingeneralequilibrium(inacon- textofforeigncurrencydebtorlowdegreeofexchangeratepass-through)uses micro-founded modelswhicharesimplysimulated.Intheabsenceofdata-basedestimatedgeneralequilibrium models,thoseworkshaveignoredsomecountry-specificfeaturesintheircomparisonofcurrency regimes. Theypaidlittleattentiontothecombinationofbothincompletepass-throughand foreigncurrencyindebtednessinasingle model⁸.

Itisknownthatthechoiceofexchangerateregimeisdependentoneconomiccircumstances andcountries’characteristics(seeFrankel(1999)).But,twonewempiricalphenomenaemerged ininternationaleconomicsinrecentyears,whichconsequencesintermsofexchangeratepolicy havenotyetbeenconsideredintheliterature:

-SomecountriesinSoutheastAsiatargettheirnominaleffectiveexchangeratesas monetary policyobjective. Atthesametime,thereisasimilarityinthecompositionoftrade-weighted effectiveexchangerateindexofthesecountriesduetothetradeintegration⁹;

- Manycountriesintheworldrecentlyexperiencedaliquiditytrapenvironmentcharacterized

6. Pegshavebeensuccessfulatreducinginflationaccordingto Ghoshetal.(1997)andLevi-Yeyatiand Sturzenegger(2001).

7.SeeDrazen(2000),TornellandLane(1999),GiavazziandPagano(1988).

8. ThestudyofDevereuxetal.(2006)isanexception,butitonlytacklesthetwofactorsinatheoretical model,whereasourframeworkisbothempiricalandtheoretical. Ontheothersideofthespectrum,Towbin and Weber(2013)studythetwofactorsonlyempirically, missingatheoretical model.

9. Maand McCauley(2008)andAglietta(2011)presentsthisstylizedfact.Forinstance,Singapore,Thailand andIndonesiastabilizetheirexchangerateagainstcurrenciesoftheirtradingpartners.

5

Generalintroduction

byaverylowshort-terminterestrate,whichisboundedatzero(i.e.zerolowerboundorZLB henceforward).IthasbeenthecaseforEuroarea,UnitedStates,Canada,UnitedKingdom, Switzerland,Japan,amongothers.

Inthiscontext,thisthesisaimsatansweringseveralquestionsrelatedtothechoiceofexchange rateregime,consideringdifferenteconomicsettings. DoSoutheastAsiacountries, mainlyin- debtedinforeigncurrency,haveanyinterestinstabilizingtheirexchangeratesinthefaceof externalshocks? Whatistheoptimal monetaryregimeinsucharegionwherethereisasim- ilaritybetweentrade-weightedbasketsofcurrenciesdefiningtheeffectiveexchangerates? Do thezerolowerbound(ZLB)haveanyparticulareffectonthechoiceof monetaryregimesand currencymisalignments? WhatarefinallytheimplicationsoftheZLBconstraintandeffective exchangeratetargetingintermsof monetaryintegration?

Thesequestionsformthebedrockofourinvestigationofnumerousneglectedissuesinthe above-mentionedliterature. Moregenerally,thisthesiscontributes,theoreticallyandempiri- cally,tothedebateonexchangeratepoliciesandmonetaryintegrationthroughfour(4)essays presentedintwoparts.

Thefirstessay(Chapter1)investigatesthechoiceoftheappropriateexchangerateregimein thecontextwhereprivatedebtisdenominatedinforeigncurrency. Toaddressthisissue,we buildadynamicstochasticgeneralequilibrium(DSGE) modelofasmallopeneconomythat incorporatesfinancialfrictionsandalternativecurrencydenominationsofdebtaswellasincom- pleteexchangeratepass-through. Weestimatethe modelusingdatafromthefiveindividual founding membersoftheAssociationofSoutheastAsianNations(ASEAN)andcomparethe welfareperformanceoffourexchangerateregimes(floating,managedfloating,targetzoneand fixedexchangerate). Wefindthe modelisabletoreplicatethe magnificationroleofbalance sheeteffectsinthefaceofexternalshocks. Moreimportantly,wefindthattheflexibleexchange rateregimewelfaredominatestheotheronesirrespectiveofwhetherdebtisdenominatedin domesticorforeigncurrency.Itisfollowedbyintermediateandfixedexchangerateregimes.In linewiththe Mundell-Flemingprescription,thisfindingsuggeststhattheexpenditureswitch- ingeffectsoutweighthebalancesheetonesduetocountries’degreeoftradeopenness.

Thesecondessay(Chapter2)explores,theoretically,theimplicationsofnominaleffectiveex- changeratetargetingpoliciesintermsof monetaryintegrationwithinaregionwherethere isasimilarityamongtrade-weightedcurrencybasketsdefiningtheeffectiveexchangeratesof

Generalintroduction

countries. Tothisend,webuildathree-countryDSGE modelanduseittocomparetheinde- pendentregimeofexchangeratetargetingagainstandmonetaryunion.Themodeliscalibrated ontheSoutheastAsiaregionandcontrolsforfinancialimperfections(riskpremium),foreign currencydebt,pricestickinessandinvestmentadjustmentcosts. Wefindthat,besidesthefact thattheallocationsarebroadlycloseundertheregimesofeffectiveexchangeratetargeting and monetaryunion,thenatureofshocksplaysa marginalrolein minordifferencebetween thetworegimes. Wefurtherfindthattargetingindependentlythenominaleffectiveexchange ratecanleadtothestabilityofbilateralexchangerateswithintheregion,whichisakindof intra-regionalfixityofexchangerates. Thisexplainswhytheallocationsandwelfareperfor- mancesofthetwoconsideredregimesaretooclose. Weconcludeonthefeasibilityof“defacto currencyarea”asemphasizedbyAglietta(2011).

Thethirdessay(Chapter3)studiestheperformanceofalternativeexchangerateregimesin thewakeofalargedeflationaryshockthatpushesthenominalinterestratetoitslowerbound, usingseveralversionsofatwo-sectortwo-country DSGE model. Weshowthat,contraryto commonbeliefduringtherecentEurocrisisandthe Mundell-Flemingrecommendation,the currencyunioncanoutweightheindependentfloatingregimeindealingwiththedurationand depthofaliquiditytrap. Althoughthewelfarelevelisconditionaltotheassetmarketstructure andthedegreeofsubstitutionbetweendomesticandforeigngoods,wefindthatthecurrency unionwelfare-dominatestheindependentfloatingforaplausiblemodelinwhichassetmarkets areincompleteandthecross-countrysubstitutabilityisreasonablyhigh.Introducingexchange rateinthemonetaryrule,whichthendefinestheindependentmanagedfloatingregime,allows forindependentpolicytooutperforma monetaryunion,highlightingtheroleoftheexchange rateregimechoiceasapreventivestrategytoaddresstheadverseeffectsofdeflationaryand recessionaryshocks.

Thefourthessay(Chapter4)investigates,empiricallyandtheoretically,theeffectsoftheZLB constraintonthesizeofcurrency misalignmentsandexplorestheirimplicationsintermsof monetaryintegrationandexchangerateregimechoices. Usingtherecentdevelopmentsinnon- stationarypaneldataeconometrictechniques,wefindthatcurrency misalignmentislargerin theindependentfloatingregimecomparedtothecurrencyunionwhenthezeroboundonnom- inalinterestrateisreached.Inparticular,weshowthattheZLBconstraintreducescurrency misalignmentsunderacurrencyunion. Weinterpretandrationalizethesefindingsusinga

7

Generalintroduction

two-sectortwo-countryDSGE modelinwhichthedurationoftheZLBconstraintisendoge- nous. Themodelsuggeststhatthehighlevelofcurrencymisalignmentundertheindependent monetaryregimerelativetothecurrencyunionintheliquiditytrapcanbeexplainedbyac- tualnominal(andreal)exchangerateappreciationoccurringintheformerregimewhereasit depreciatesunderthelatter.

Finally,beyondtheirfocusontheexchangeratepolicyliterature,thefouressaysofthisdoc- toralthesiscombinefeaturesfromseveralliteratures.Fromtheopen-macroliterature,thiswork usesone,twoandthreeopen-economyDSGEmodelswithstickyprices,endogenousinvestment dynamics,producercurrencypricing,localcurrencypricing,tradableandnon-tradablesectors. Fromthecreditchannelliterature,itincorporatesfinancialfrictionsintheformofcountry-risk premiumsensitivetothecountry’snetforeignassetpositionwithrespecttoGDPandfirm’s specificriskpremiumthatissensitivetonetwealthrelativetopurchasedcapital(leveragera- tio).Fromthecrisisliterature,itemphasizestheroleofforeign-currencydenominationofdebt. Fromthezerolowerboundliterature,itincludestheendogenousdurationoftheliquiditytrap anddeterminestheroleoftheconstrainedinterestrateinthechoiceofexchangerateregimes andthecurrency misalignments. Fromthelong-runexchangerateliterature,thisworkuses theefficientlong-runexchangerateinordertoderivecurrency misalignments.

Additionally,thethesisalsoborrowsfromtheempiricalliteraturebyestimatingseveralver- sionsofasmallopeneconomyDSGE modelusingBayesianeconometric methods,performing meancomparisontestsandbyusingtherecentdevelopmentsofthepaneldataeconometricto estimatethelong-runrealexchangerateandpanelVectorErrorCorrection Models(VECM).

PARTIEXCHANGE RATE REGIMES AND MONETARYINTEGRATION FORSMALL OPEN ECONOMIES INDEBTEDINFOREIGN CURRENCY

Theresearchofthispartisfocusedontheexchangerateregimeselectionand monetary integrationinaregion madeupofsmallopeneconomiesindebtedinforeigncurrency,which manageexchangeratesagainstsimilartrade-weightedcurrencybasketsdefiningtheireffective exchangerates. Twoessaysaredevotedtothispartofthethesis. Usinganestimatedsmall open“New Keynesian” DSGE model,thefirstessay(inchapter1)studiesthechoiceofan appropriateexchangerateregimeforeachcountryofsucharegion. A multi-country modelis usedinthesecondessay(chapter2)inordertoaccountfortheregionalaspectintheanalysis ofimplicationsofnationalindependentpoliciesfortheregional monetaryintegration.

Chapter1

Externa lshocks ,exchangeratereg imes

andfore ign-currencyindebtedness

1.1. Introduction

CHAPTER1-EXTERNALSHOCKS,EXCHANGERATEREGIMESAND FOREIGN-CURRENCYINDEBTEDNESS

1 .1 .Introduct ion

TherecentuseoftheexchangerateasapolicytoolbyemergingSoutheastAsiancountries forimprovingtheircompetitivenessandboostingtheireconomicgrowthhasrevivedinterestin thestudyoftheirexchangeratepolicy.Intheaftermathofthe1997Asiancrisis,exchangerate policiesin manyAsianeconomieshavebeen markedbya“fearoffloating”behaviour(Calvo andReinart(2002)).Thismeansthatcountriesthatclaimtheyarefloatingdonotinpractice. Oneofthereasonsforthisislinkedtotheinterpretationsofthecrisis.Indeed, manyauthors andobservershavepointedoutthelevelofdebtdenominatedinforeigncurrencyasoneofroot causesofthecrisisexacerbation(Aghionetal.(2001),Eichengreenand Hausmann(1999), Krugman(1999),CalvoandReinhart(2000)).

DuringtheAsiancrisis,countrieshaveexperiencedasharpcurrencydepreciationandarise intheirriskpremia. Theintuitionisthatfinancialimperfectionslinkedtotheendogenous riskpremium magnifytheeffectofshocks. Duetotheforeigncurrencydebt,exchangerate depreciationmayworsenfirms’balancesheets.Thisbalancesheeteffect,magnifiedbyfinancial imperfections,causesacontractionininvestmentandtherefore maydepressoutput. Fixed exchangerateshavethenbeenpreferredtofloatingonesin(emerging)countrieswhichwere stronglyindebtedinforeigncurrency.

Inrecentyears, mostoftheSoutheastAsiancountrieshaveallowedtheircurrenciestofloat tosomeextentandarejustcharacterizedbya“fearofappreciation”asstatedbyLevy-Yeyati andSturzenegger(2007). However,thesecountriesmainlyremainindebtedinforeigncurrency whentheyallowtheircurrenciestodepreciate.Figures1.1and1.2illustratethehighlevelof debtdenominatedinforeigncurrencyforselectedSoutheastAsiancountries¹.

Inthischapter,wefocusonansweringthreeinterrelatedquestions.Isthecurrentlevelof foreign-currencydenominateddebtinthesecountriescompatiblewithfloating? Whatisthe bestexchangerateregimeforSoutheastAsiancountries? Dothesecountries mainlyindebted

1. UsingtheThomson’sIFRPlatinumdatabase,Cook(2004)mentionsthatupto88%ofloanstoemerging Asiancountries(between1992and1997)weredenominatedeitherinUSDorinYen.

11

1.1. Introduction

Figure1.1–Percentageofresidentbankliabilitiesdenominatedinforeign currency

Datasource: BIS.

Figure1.2–Percentageofgrossexternal(short-term)debtdenominated inforeigncurrency

Datasource: The WorldBank(QuarterlyExternalDebtStatistics).

inforeigncurrencyhaveanyinterestinstabilizingtheirexchangerates? Tothisend, we investigatealternativeexchangerateregimesforthesecountries.Besidesthehighlevelsofboth riskpremiumandforeign-currencydenominateddebt,wetakeintoaccountthelowdegreeof exchangeratepass-throughinthesecountries².

SomerecenttheoreticalstudiessuchasCook(2004),EleckdagandTchakarov(2007),Ces-

2. Thereisempiricalevidencehighlightingthelowdegreeofexchangeratepass-throughinemergingcountries (seeAleemandLahiani(2014),Ca’zorzietal.(2007),BussièreandPeltonen(2008)for moredetails).

1.1. Introduction

pedesetal.(2004)andDevereuxetal.(2006)includefinancialfrictionsintheirmodelinorder toanalyzedifferentcurrencyregimes.Inparticular,Cook(2004)andEleckdagandTchakarov (2007)finda moreimportantroleoffixedexchangeratesinstabilizingthe macroeconomic fluctuationsofemergingeconomies,whereasCespedesetal.(2004)andDevereuxetal.(2006) underlinetheprimacyofthefloatingregimeoverthefixedexchangerate,inaccordancewith the Mundell-Flemingframework. However,Cook(2004)andCespedesetal.(2004)useover- simplifiedmodels,assumingcompleteexchangeratepass-throughandperfectcapitalmobility. EleckdagandTchakarov(2007)’smodelassumesthecompleteexchangeratepass-throughand flexibleimportprices, whichseemslessrealistic. Furthermore,noneoftheaforementioned studieshastakenintoaccountboththeexternalfinanceandthecountry-riskpremiaintheir modelwithfinancialsector modelling.Eventhoughthesestudieswerefocusedonthegeneral issueofexchangerateregimesinemergingcountries,theydidnotprovideanyspecificcountry analysisanddata-basedestimationoftheir models. Finally,theseauthorsdidnotexplorea widerangeofexchangeratepoliciesandpaidlittleattentiontotheoptimalpolicyframework.

Thischapterrespondstotheseshortcomingsanddevelopsa“New Keynesian”dynamic stochasticgeneralequilibriummodel,whichispartiallyestimatedforeachofthefive(5)found- ingcountriesoftheASEAN(Thailand,Indonesia, Malaysia,Singapore,andPhilippines)using quarterlydatafrom2000to2011.Theaimistocomparefouralternativeexchangerateregimes forthesecountriesusingtheoptimal monetarypolicyapproach. Weincorporatethefinancial accelerator mechanismàlaBernankeetal. (1999)andforeign-currencydenominateddebt inthe modelinordertotakeintoaccounttheaforementionedfinancialfrictions. Wefurther extendthe modelforanalysingthescenarioofdomestic-currencydenominateddebt.

Wecompareforeachcountrythewelfare-performanceofdifferentmonetaryregimesintheface ofcountry-riskpremiumandforeigndemandshocks.Theseexternalshocksarechosenbecause oftheirdestabilizingeffectsoneconomiescharacterizedbyforeigncurrencyindebtedness,such asSoutheast Asianeconomies³. Fortheseeconomies, wefindthatthefloatingregimeout- weighstheotheronesintermsofeconomicstabilization,followedbyintermediateandfixed exchangerateregimes. Thisfindingisconsistentirrespectiveofthecurrencydenominationof debt. Wealsoshowthatthehigherthedegreeoftradeopenness,the moredominantisthe flexibleexchangerateregime.

3.Seeforinstance,the1997Asiancrisis,the2007globalcrisis,andthe2013emergingcurrencycrisis.

13

1.1. Introduction

Theworkisorganizedinfivesections.First,wedescribethe modelinsection1.2.Section1.3 presentsthemodelparametrizationandestimationandtheoptimalmonetaryrules.Insection 1.4,wepresentourresultsandfinallysection1.5concludes.

1.2. The model

1 .2 . The mode l

Wedevelopasmallopeneconomy DSGE model, whichcombinesthefinancialaccelera- tor mechanismandforeign-currencydenominateddebt. The modelischaracterizedbysticky prices,incompleteexchangeratepass-through,capitaladjustmentcostsandimperfectmobility ofcapital.

Theeconomyispopulatedbyhouseholds,entrepreneurs,producersofcapital,retailersand the monetaryauthority. Householdsconsumethefinaldomesticandforeignretailgoods,and providelabourtoentrepreneurs.Theyborrowinbothdomesticandforeigncurrencies. House- holdsownretailersandreceivetheirprofits. Entrepreneursproduceintermediate(wholesale) goods,usingcapitalandlabour,andsellthemtodomesticgoodsretailers.Theyalsoborrowin theinternationalfinancialmarketinforeigncurrencyinordertofinancetheirpurchaseofcap- ital. Thepresenceofasymmetricinformationbetweenentrepreneursandinternationallenders isthesourceofafinancialfriction(firm-specificriskpremium),implyingthedependenceof theentrepreneurialdemandonthefirms’financialposition. Entrepreneurialloansaresubject tothecountry-riskpremiumasanadditionalfinancialfriction. Capitalproducersbuildnew capitalandsellittoentrepreneurs. Domesticandimportedgoodsretailerssetnominalprices offinalgoodsàlaCalvo(1983). Thispricestickinessjustifiesthepresenceof monetarypolicy inthe model.

Thestructureofthe modelissummarizedbythefollowingflowchart:

15

1.2. The model

1.2.1. Households

Theeconomyispopulatedbyacontinuumofinfinitelylivedhouseholdsintheunitinterval. Therepresentativehousehold maximizesthefollowingintertemporalexpectedutility:

Et

∞

t=0β^t (Ct)^1−σ

1−σ −(Lt)^1+η

1+η (1.1)

where Ctistheaggregateconsumption,Ltrepresentsthenumberofhours worked,Etthe expectationoperatorconditionaloninformationavailableattimet,σistheinverseofthein- tertemporalelasticityofsubstitution,η>0measurestheinverseofthelaboursupplyelasticity and0<β<1isthesubjectivediscountfactoroftherepresentativehousehold.

TheconsumptionindexCtisaCESaggregateoftherepresentativehousehold’sconsumption ofdomesticandimportedgoods:

Ct= (1−a)^1θ(CH,t)^θ−1θ +a^1θ(CM,t)^{θ−1θ θ−1θ} (1.2) CH,tandCM,t indicatetheaggregateconsumptionindexofdomesticandimportedgoodsfrom therestoftheworld,respectively;θ >1,istheelasticityofsubstitutionbetweenthesetwo typesofgoodsanda∈[0,1]representstheshareofimportedgoodsintheconsumptionbasket. Theaggregatepriceindex(definedasthe minimumexpenditurerequiredforbuyingacon-

1.2. The model

sumptionunit)associatedto(1.2)isgivenby:

Pt= (1−a)(PH,t)^1−θ+a(PM,t)^{1−θ1−θ1} (1.3) wherePH,tandPM,t arerespectivelythedomesticpriceofdomestic-producedgoodsandthe domesticpriceofimportedgoodsfromtherestoftheworld. Thebasketsofdomesticand foreigngoodsarealsoaCESaggregateofdifferentiatedvarietiesofgoods,suchas

CH,t =(₀¹CH,t(j)^χ−1χ dj)^χ−1χ andCM,t =(₀¹CM,t(j)^χ−1χ dj)^χ−1χ , wherej∈[0,1]indicatesthe varietyofgoods,χ > 1theelasticityofsubstitutionbetweengoodsvarietiesandfinally, CH,t(j)andCM,t(j)representtheconsumptionofavarietyjofthefinaldomesticandim- portedgoodsfromtherestofthe world. Thecorrespondingpricesarethereforegivenby: PH,t=(₀¹PH,t(j)^1−χdj)^1−χ1 andPM,t =(₀¹PM,t(j)^1−χdj)^1−χ1 .

HouseholdschoosetheirconsumptionCH,tandCM,t insuchawayastominimizetheircon- sumptionexpenditure.Theindividualdemandsfordomesticandimportedgoodsderivedfrom theexpenditure minimizationaregivenby⁴:

CH,t=(1−a)(PH,t

Pt)^−θCt

CM,t=a(PM,t

Pt)^−θCt

(1.4)

Therepresentativehousehold’sbudgetconstraintisdefinedby:

PtCt+Rt−1Bt−1+R_t−1ΨD,t−1StDH,t−1=WtLt+Bt+StDH,t+Λt (1.5) Ateachperiodt,householdsborrowintheformoftwotypesofbonds:Btissuedindomestic currencywithanominalinterestratert=Rt−1,andDH,tinforeigncurrencywithanominal interestrater_t(ΨD,t) =(R_t−1)(ΨD,t)⁵. Afinancialfrictionisintroducedinthe modelin ordertotakeintoaccounttheimperfectcapital mobilityandallowstationarityofnetforeign assets(Schmitt-GrohéandUribe,2003)⁶.Infact,whentheyborrowfromtherestoftheworld,

4. The minimizationproblemis: min

CH,t,CM,t,CtPH,tCH,t+PM,tCM,t=PtCt

5. NotethatDH,tcanbeeitherpositive(householdisnetdebtor)ornegative(householdisnetcreditor). 6.Schmitt-GrohéandUribe(2003)showthattheborrowingcostallowstoachievestationarityinthenet foreignassetposition.

17

1.2. The model

householdspayacountry-riskpremiumΨD,tdefinedasinAdolfsonetal.(2008):

ΨD,t(dt,Zt) =expψD(^S_YP^tD_t^t+Zt),wheredt=^S_YP^tD_t^tisthereallevelofthenetforeignasset positioninpercentageofsteady-stateoutputandtheriskpremiumΨD,t isincreasinginthe levelofinternationaldebt((ΨD,t)_dandΨD(0,0)=1);Dtistotaldebtofthecountry(Dt= DH,t+DE,t)andDE,tmeasurestheexternaldebtofentrepreneursdefinedinsubsection1.2.3; ψD istheelasticityofthecountry-riskpremium withrespecttothedebt-outputratioand Ztrepresentsanexogenousshockthatisanunexplainedpartofthecountry-riskpremium:

Zt∼AR(1)andlog(Zt)=ζZlog(Zt−1)+εZ,t,withεZ,t∼i.i.d.(0,σ²_εZ).

Theotherrevenueflowsofhouseholdscomefrom,ateachperiodt,theirnominalwageWt, theprofitsΛtoffirms.Strepresentstheeffectivenominalexchangerate(expressedintermsof unitsofdomesticcurrencyperunitofforeigncurrency)andRt−1Bt−1+R_t−1ΨD,t−1StDH,t−1is thetotalgrossamountofdebtthatisreimbursedatt-1.

Therepresentativehouseholdchoosesthepathsfor{Ct,Lt,Bt,DH,t}^∞₀ inordertomaximize (1.1)subjecttothebudgetconstraint(1.5). Thefollowingfirstorderconditionshold:

(Lt)^η

(Ct)^−σ=Wt

Pt=wt (1.6)

(Ct)^−σ=βRtEt (Ct+1)^−σ Pt

Pt+1 (1.7)

(Ct)^−σ=βR_tΨD,t(dt,Zt)Et (Ct+1)^−σ Pt

Pt+1

St+1

St (1.8)

Combiningequations(1.7)and(1.8)leadstotheusualuncoveredinterestratepartycondition (UIP)undertheincompletemarketassumption.Theselasttwoequationssuggestthat,inequi- librium,the marginalbenefitofsavingequalsits marginalcost. Condition(1.6)characterizes consumers’optimallaboursupplyandwtistherealwage.

1.2.2.Inflation, Termsoftrade,Exchangerateand Deviationfromthelawofone price

Inthissection,wederivetherelationsbetweentheCPI-inflationrate,therealexchange rate(RER)andthetermsoftrade.

Thelog-linearizationaroundthenon-stochasticsteadystateofequation(1.3)givestherelation betweentheCPI-inflationrate(πt),domesticgoodsinflation(πH,t)andimportedgoodsinflation

1.2. The model

(πM,t)as⁷:

πt=(1−a)πH,t+aπM,t (1.9)

wherethe“hat”onavariable meansitsdeviationfromthesteady-state. Then,wedefinethe termsoftradeby:

TOTt=PM,t

PH,t (1.10)

whereTOTtisthetermsoftradeindexbetweenthehomecountryandtherestoftheworld. Combiningthelog-linearizedversionsofequations(1.3)and(1.10)providesanexpressionof inflationinfunctionofthetermsoftradesuchthat:

πt=πH,t+a∆tott (1.11)

with∆tott=πM,t−πH,tand∆ symbolizesthefirstdifference.

Furthermore,Stbeingthenominalexchangerate,thedefinitionoftherealexchangerateis:

RERt=StP_t

Pt (1.12)

Undertheassumptionofincompleteexchangeratepass-through,thelawofonepriceisnot verifiedandthereforePM,t = StP_t. Thedeviationsfromthelawofonepricearetherefore definedas:

LOPt=StP_t

PM,t (1.13)

Thispricegapisintroducedasin Monacelli(2005)bysupposingthatimportsarepricedin localcurrency(localcurrencypricing)(seeParagraph1.2.3.3).

Usingthelog-linearizedversionsof(1.10),(1.12)and(1.13)with(1.11)wehave:

rert=lopg_t+(1−a)tott (1.14)

7. The methodofthelog-linearizationispresentedinAppendixA.3.2.

19

1.2. The model

1.2.3. Productionsector

1.2.3.1.Entrepreneursandthefinancialaccelerator

Thepresenceofentrepreneursallowsintroducingthefinancialacceleratormechanisminthe modelandunderstandinghowtheforeign-currencydenominateddebtcouldaffectasmallopen economy.

Intheeconomy,entrepreneurs manageacontinuumoffirmsj∈ [0,1]whichproducedif- ferentiatedintermediategoodsinaperfectlycompetitive marketfollowingtheCobb-Douglas technology:

Yt(j)=AtKt(j)^αLt(j)^1−α (1.15)

whereAtisatechnologicalshockwhichiscommontoallfirmsandfollowsanAR(1)process givenby:log(At) =ζAlog(At−1)+εA,t,with εA,t ∼ i.i.d(0,σ_ε²_A).KtdenotescapitalandLt

representslabour,onlysuppliedbyhouseholds(forsimplicity,weassumethatentrepreneurs labourisequaltoone)⁸;α∈[0,1]istheshareofcapitalintheproductiontechnology. Giventhe pricesofproductionfactors,firmswillminimizetheircostssubjecttotheproductiontechnology (1.15).Thefirstorderconditionsofthecostminimizationproblemgivethefollowingaggregate factorpayments:

wt=(1−α)mctYt

Lt

PH,t

Pt (1.16)

mpct=αmctYt

Kt

PH,t

Pt (1.17)

wheremctisthereal marginalcost,mpct=^MPC_Pt^tdenotesthereal marginalproductivityof capitalandwtistherealwage.

Wesupposethatentrepreneursfaceaconstantprobability (1−ν)ofleavingtheeconomyin eachperiodt. AsinBernankeetal.(1999),thisassumptionismadetoensurethattheynever accumulateenoughfundstofullyself-financetheirownactivities.Theyarethereforesubjectto afinancialconstraint.Capitalpurchasedbyentrepreneursisfinancedpartlybytheirnetworth

8. Unlikeourframework, manyauthorsintheliterature(Devereuxetal.(2006),Bernankeetal.(1999), BadarauandLevieuge(2011),amongothers)considertheentrepreneurs’hoursworkedina morenoticeable way. However,thisassumptiondoesnotaffectourfindings.

1.2. The model

andborrowing. Weassumethattheyonlyborrowfromforeignlenders(andthence,inforeign currency). Thishighlightsthefinancialvulnerabilityofthecountriesconsidered. LetQtand Ntbethepriceofcapitalsoldtoentrepreneursbycapitalproducersandtheentrepreneurial networthpredeterminedatt-1,respectively. Attheendoftheperiodt,theentrepreneur’s budgetconstraintisgivenby:

PtNt+1=QtKt+1−StDE,t+1 (1.18)

where StrepresentstheexchangerateandDE,t+1,theexternalfundborrowedintforthe purchaseofcapitalusedinthenextperiodt+1. Equation(1.18)isanaccountingidentity whichmeansthattheentrepreneur’snetworthisdefinedasthedifferencebetweenitsassetsand liabilities.Anunanticipateddepreciationofthedomesticcurrency(correspondingtoanincrease inSt)immediatelyleadstoanincreaseinliabilitiesandthereforeariseinthevulnerabilityof theentrepreneur.EntrepreneursareriskneutralandchoosethelevelofcapitalKt+1associated withthedebtlevelDE,twhichmaximizestheirprofits.Theoptimalconditionissuchthat,the expectedrealreturnoncapitalEtRK,t+1isequaltothe marginalcostofexternalfunds⁹:

EtRK,t+1=Et R_tΨD,tΦ St+1

St

Pt

Pt+1 (1.19)

Φisthefirm’sspecificriskpremiumsuchasΦ= _q^N_tK^t+1_t+1 ^−γ,whereγmeasurestheelasticity ofthespecificriskpremiumwithrespecttothecapital-to-networthratio,qtistherealprice ofcapitaland(Φ)<0withΦ(1)=1.

Theentrepreneur’soptimaldemandforcapitalguaranteesthattherealreturnoncapitalRK,t

equalsthesumofthemarginalproductivityofaunitofcapitalmpctandthevalueofthisunit ofcapital(netofdepreciation)int:

RK,t=mpct+(1−δ)qt

qt−1 (1.20)

whereδisthedepreciationrateofcapital. Notethat,ifthecondition(1.20)isnotsatisfied, theentrepreneur’sdemandforcapitalwouldbeeitherzeroorinfinite.

Finally,theevolutionoftheaggregateentrepreneurialnetworthintheeconomydependsonthe

9. Theoptimalconditionsarederivedfromtheoptimalcontractbetweenthelenderandtheborrower,which ispresentedinAppendixA.1.

21

1.2. The model

financialwealthaccumulatedinpreviousperiodsbysurvivingentrepreneursplusthebequest, Ωt,thatnewlyenteringentrepreneursreceivefromentrepreneurswholeavetheeconomy,and evolvesaccordingto:

Nt+1=ν[RK,tqt−1Kt−R_t−1ΨD,t−1 St

St−1

Pt−1

Pt

Nt

qt−1Kt

−γ

(qt−1Kt−Nt)]+(1−ν)Υt(1.21) Equation(1.21)clearlyshowsthatthereexistthreesourcesofvariationsintheentrepreneurial net worth:thereturnoncapital(RK,t)thataffectstheentrepreneur’srevenue,thesecond sourceisthechangesintherealcostofdebtrepayment(i.e.theinterestrateoftherestofthe worldplusboththecountry-riskandtheentrepreneur’sspecific-riskpremia). Anincreaseinthe interestrateoftherestoftheworld,forexample,wouldreducetheentrepreneur’snetworth. Thethirdsourceofchangeintheentrepreneurialnetworthistheexchangerate. Thereby,an unanticipateddepreciationreducesthenetworthoftheentrepreneur.

1.2.3.2. Capitalproducers

CompetitivecapitalproducersusealineartechnologytoproducenewcapitalRK,t+1using theexistingcapitalandinvestinginfinalgoodssoldbyretailers. Thebasketofinvestment goodsis madeupinthesamewayastheconsumptiongoodsbasket:

It= (1−a)^1θ(IH,t)^θ−1θ +(a)^1θ(IM,t)^{θ−1θ θ−1θ} (1.22) Weassumethatcapitalproductionissubjecttoaquadraticadjustmentcost, ^ψ₂^I _K^It_t−δ²Kt. Theaggregatecapitalstockusedincapitalproductionevolvesaccordingto:

Kt+1=[It

Kt−ψI

2 It

Kt−δ²]Kt+(1−δ)Kt (1.23)

whereψIdeterminesthesizeofcapitaladjustmentcosts.

Capitalproducerschoosethelevelofinvestmentthat maximizestheirprofits(QtIt−Pt(It+

ψI

2(_K^It_t−δ)²Kt)). Thecorrespondingoptimizationproblemis:

maxIt qtIt−It−ψI

2 It

Kt−δ²Kt

1.2. The model

Thefollowingequilibriumconditionholds: qt−ψI It

Kt−δ =1 (1.24)

When ψI=0 (i.e. absenceofadjustmentcosts),qtisequaltoone. This meansthatthe presenceofadjustmentcostsnecessarilyimpliesthatthecapitalpriceqtistime-varying. The condition(1.24)definesthestandardTobin’sqthatrelatesthepriceofcapitaltothemarginal adjustmentcost.

1.2.3.3. RetailersandInflationdynamic

Inthispartofthe model,wefollow Monacelli(2005).Intheeconomy,thereexistretailers ofdomesticgoods,whoselldomesticproducedgoodsonthehomeandforeign markets,and retailersofimportedgoods.Thepresenceofretailersallowsustointroducethepricestickiness inthe model. Retailersofdomesticgoodspurchasewholesalegoodsfromentrepreneursata priceequaltotheentrepreneur’snominal marginalcost. Theyrepackagethesegoodswithout anyadditionalcostandsellthemasfinalgoodsatthedomestic marketpricePH,t andthe foreign marketpricePX,t. Weassumethatretailersoperateina monopolisticallycompetitive domestic market. Intheperspectiveofthesmallopeneconomy, wealsosupposethatthe pricesofdomesticproducedgoodsattheborderoftheexportingcountryarePX,t=PH,t/St

(expressedinforeigncurrency).

FollowingCalvo(1983),aproportion(1−φ)ofretailersofhomeproducedgoodsre-optimize theirpricesbysetting˜PH,ttimet,whiletherestoftheretailers(φ)keepstheirpricesunchanged atPH,t−1. Therepresentativefirmjsetsthevalueof˜PH,tthat maximizesthediscountedsum ofitsexpectedprofits:

˜max

PH,t(j)E0

∞

s=0(βφ)^sλt+s

λt[YH,t+s(j)(˜PH,t(j)−PH,t+smct+s)]

subjecttothefollowingdemandfunction:YH,t+s(j)= ^P˜H,t+s_PH,t+s^{(j) −χ}YH,t+swiththecorrespond- ingfinalaggregategoods,YH,t = ₀¹YH,t(j)^χ−1χ

χ−1χ

whereχistheelasticityofsubstitution betweenvarietiesofgoods,^λ_λ^t+s_t istheratioofhouseholds’ marginalutilityint+srelativeto

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1.2. The model

thatint. Thefirstorderconditionyields¹⁰: P˜H,t(j)= χ

χ−1Et{ ^∞_s=0(βφ)^sλt+sYH,t+s(j)PH,t+smct+s)}

Et{ ^∞_s=0(βφ)^sλt+sYH,t+s(j)} (1.25) Theaggregatepricelevelevolvesaccordingto:

PH,t=[(1−φ)(˜PH,t)^1−χ+φ(PH,t−1)^1−χ]^1−χ1 (1.26) Thelog-linearizationaroundthesteadystateof(1.25)and(1.26)leadstothefollowingstandard

“NewKeynesian”Phillipscurve: πH,t=βEtπH,t+1+(1−φ)(1−βφ)

φ mct (1.27)

whereπH,tistheinflationratefromdomesticproducedgoods.

Retailersofimportedgoodsalsooperateinamonopolisticallycompetitivemarketandthey purchasefinalforeigngoodsattheprice:P_H^G_,t=StP_t (inthedomesticcurrency). Theyresell thesegoodsonthedomestic marketattheretailpricePM,t,suchthatPM,t =StP_t,assuming thatthelawofonepricedoesnotholdattheimportlevel. Thisintroducestheincomplete exchangeratepass-throughinthe model.

Aspreviously,retailersofimportedgoodssettheirprices àlaCalvo. Let(1−φ^m)bethe fractionoffirmsthatre-optimizestheirpricesateachperiodtand(φ^m)thefractionthatdoes not. Theoptimizationproblemisidenticaltothatpreviouslydescribedfordomesticgoods retailers,exceptthereal marginalcostthatismcM,t =^S_P^t_M,t^Pt forretailersofimportedgoods. Therefore,theinflationrateofimportedgoodsfromtherestoftheworldsatisfiesthefollowing

“NewKeynesian”Phillipscurve:

πM,t =βEtπM,t+1+(1−φ^m)(1−βφ^m)

φ^m lopg_t (1.28)

10.SeeAppendixA.2.forthe methodofsolvingtheoptimizationproblem.

1.2. The model

1.2.4.Four monetaryregimes

Inthischapter,weinvestigatetheperformancesoffour(4)alternativemonetaryregimesfor eachcountry. Thesemonetaryregimesareidentifiedbythemonetaryrulesdescribedbelow¹¹. 1.2.4.1. Managedfloatingregime

Inthisregime,the monetaryauthorityfollowsapolicyrulewhichisaugmentedtoallow thenominalinterestratetoreacttodeviationsinnominalexchangerate movementsfromits steady-statevalue,inadditiontothereactiontodeviationsininflationandoutputfromtheir steady-statevalues. Thepolicyruleistherefore:

log(Rt

R)=β0log(Rt−1

R )+(1−β0)[β1log(πt

π)+β2log(Yt

Y)+β3log(∆St

∆S)]+εr,t (1.29) withεr,t∼i.i.d.(0,σ_ε²_r).R,π,Yand∆Sarerespectivelythesteady-statevaluesofRt,πt,Yt

and∆St;β0,β1,β2,andβ3arethepolicycoefficientschosenbythecentralbank.β0isthe smoothingparameteroftheinterestrate.

1.2.4.2.Floatingregime

Underthefloating monetaryregime,thecentralbankdoesnotcontrolthedynamicofthe exchangerate, whichbecomescompletelyflexible.Insuchacase,β3=0 (andβ1> 1and β2< 1)inequation(1.29),thepolicyruleisthenassumedtobeastandardTaylorrulein whichthecentralbankadjuststhenominalinterestrateinresponsetodeviationsin CPI- inflationandoutputfromtheirsteady-statevalues.

1.2.4.3.Fixedexchangerateregime

Inthefixedexchangerateregime,thecentralbankmaintainstheexchangerateataprede- terminedandconstantlevel:St= ¯Sforeacht. Therefore,thecentralbanksetsthenominal interestrateinsuchawaythattheuncoveredinterestrateparityconditionholds.

1.2.4.4. Targetzoneregime

Underthis monetaryregime,thecentralbank managestheexchangerate,whichwouldbe adjustedaroundacentralparity(differentfromthesteadystate). Thetargetzoneregime

11. Following Monacelli(2004),Faia(2010),CookandDevereux(2014)andBornetal.(2013),themonetary regimecanbeidentifiedbyaTaylor-typepolicyrule.

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