A corporate Balance-Sheet Approach to Currency Crises

The paper presents a general equilibrium currency crises model of the "third generation", in which the possibility of currency crises is driven by the interplay between private firms' credit-constraints and nominal price rigidities. Despite our emphasis on microfoundations, the model remains sufficiently simple that the policy analysis can be conducted graphically. The analysis hinges on two features: i) ex post deviations from purchasing power parity, ii) credit constraints a la Bernanke-Gertler, iii) foreign currency borrowing by domestic firms, iv) a competitive banking sector lending to firms and holding reserves and a monetary policy conducted either through open market operations or short-term lending facilities. We first show that with a positive likelihood of a currency crises, firms may indeed find it optimal to borrow in foreign currency, following Chamon (2001). Second, we derive sufficient conditions for the existence of sunspot equilibrium with currency crises. Third, we show that a reduction in the monetary base through restrictive open market operations is more likely to eliminate the poaaibility of currency crises if at the same time the central bank does not impose excessive constraints on short-term lending facilities.

Financial Liberalization and Volatility in Emerging Market Economies

The recent East Asian crisis has highlighted the relationship between financial development and output volatility. In this essay we develop a simple model of a small open economy producing a tradeable good using a non-tradeable input and where firms access to borrowings and investment depends on current cash flows. We then show, first that macroeconomic volatility only occurs at intermediate levels of financial development; second, that whilst full financial liberalization, including an unrestricted opening to foreign lending, can destabilize an emerging market economy, in contrast output volatility can be avoided if the same economy opens up to foreign direct investment only. We also draw several policy conclusions regarding the adequate responses to financial crises.emerging markets; volatility; financial liberalization

A Corporate Balance-Sheet Approach to Currency Crises

This paper presents a general equilibrium currency crisis model of the 'third generation', in which the possibility of currency crises is driven by the interplay between private firms' credit-constraints and nominal price rigidities. Despite our emphasis on microfoundations, the model remains sufficiently simple that the policy analysis can be conducted graphically. The analysis hinges on four main features: i) ex post deviations from purchasing power parity; ii) credit constraints a la Bernanke-Gertler; iii) foreign currency borrowing by domestic firms; iv) a competitive banking sector lending to firms and holding reserves and a monetary policy conducted either through open market operations or short-term lending facilities. We first show that with a positive likelihood of a currency crisis, firms may indeed find it optimal to borrow in foreign currency, following Chamon (2001). Second, we derive sufficient conditions for the existence of a sunspot equilibrium with currency crises. Third, we show that a reduction in the monetary base through restrictive open market operations is more likely to eliminate the possibility of currency crises if at the same time the central bank does not impose excessive constraints on short-term lending facilities.financial crisis; foreign currency debt; monetary policy

Financial Liberalization and Volatility in Emerging Market Economies

The recent East Asian crisis has highlighted the relationship between financial development and output volatility. In this essay we develop a simple model of a small open economy producing a tradeable good using a non-tradeable input and where firms access to borrowings and investment depends on current cash flows. We then show, first that macroeconomic volatility only occurs at intermediate levels of financial development; second, that whilst full financial liberalization, including an unrestricted opening to foreign lending, can destabilize an emerging market economy, in contrast output volatility can be avoided if the same economy opens up to foreign direct investment only. We also draw several policy conclusions regarding the adequate responses to financial crises.

The Demand for Liquid Assets, Corporate Saving, and Global Imbalances

In the recent decade, capital outflows from emerging economies, in the form of a demand for liquid assets, have played a key role in the context of global imbalances. In this paper, we model the demand for liquid assets by firms in a dynamic open-economy macroeconomic model. We find that the implications of this model are very different from standard models, because the demand for foreign bonds is a complement to domestic investment rather than a substitute. We show that this complementarity is at work when an emerging economy is on its convergence path or when it has a higher TFP growth rate. This framework is consistent with global imbalances and with a number of stylized facts such as high corporate saving rates in high-growth, high-investment, emerging countries.capital flows; global imbalances; working capital; credit constraints

National Saving and International Investment

This paper extends earlier work by Feldstein and Horioka on the relation between domestic saving rates and international capital flows or, equivalently, between domestic saving rates and domestic investment. The basic conclusion of the present analysis is that an increase in domestic saving has a substantial effect on the level of domestic investment although a smaller effect than would have been observed in the 1960s and 1970s. The savings retention coefficient for the 1980-86 period is 0.79, down from 0.91 in the l960s and 0.86 in the 1970s. The more closely integrated economies of the EEC also appear to have more outward capital mobility (i.e., a lower saving retention coefficient) than other OECD countries. There is no support for the view that the estimated saving-investment relation reflects a spurious impact of an omitted economic growth variable. Although budget deficits are inversely related to the difference between private investment end private saving, we reject the view that this reflects an endogenous response of fiscal policy in favor to the alter-native interpretation that the negative relation is evidence of crowding out of private investment by budget deficits. This interpretation is supported by the evidence that domestic investment responds equally to private saving and to budget deficits. The implication of the analysis thus supports the original Feldstein-Horioka conclusion that increase in domestic saving does raise a nation's capital stock and therefore the productivity of its workforce. Similarly, a tax on capital income is not likely to be shifted fully to labor and land by the outflow of enough capital to maintain the real rate of return unchanged.

A Scapegoat Model of Exchange Rate Fluctuations

While empirical evidence finds only a weak relationship between nominal exchange rates and macroeconomic fundamentals, forex markets participants often attribute exchange rate movements to a macroeconomic variable. The variables that matter, however, appear to change over time and some variable is typically taken as a scapegoat. For example, the current dollar weakness appears to be caused almost exclusively by the large current account decit, while its previous strength was explained mainly by growth differentials. In this paper, we propose an explanation of this phenomenon in a simple monetary model of the exchange rate with noisy rational expectations, where investors have heterogeneous information on some structural parameter of the economy. In this context, there may be rational confusion about the true source of exchange rate fluctuations, so that if an unobservable variable aects the exchange rate, investors may attribute this movement to some current macroeconomic fundamental. We show that this effect applies only to variables with large imbalances. The model thus implies that the impact of macroeconomic variables on the exchange rate changes over time.

Why Do Consumer Prices React less than Import Prices to Exchange Rates?

It is well known that the extent of pass-through of exchange rate changes to consumer prices is much lower than to import prices. One explanation is local distribution costs. Here we consider an alternative, complementary, explanation based on the optimal pricing strategies of firms. We consider a model where foreign exporting firms sell intermediate goods to domestic firms. Domestic firms assemble the imported intermediate goods and sell final goods to consumers. When domestic firms face significant competition from other domestic final goods producing sectors (e.g., the non-traded goods sector) we show that they prefer to price in domestic currency, while exporting firms tend to price in the exporter's currency. In that case the pass-through to import prices is complete, while the pass-through to consumer prices is zero.

Modeling Exchange Rates with Incomplete Information

Recent research has shown that relaxing the assumptions of complete information and common knowledge in exchange rate models can shed light on a wide range of important exchange rate puzzles. In this chapter, we review a number of models we have developed in previous work that relax the strong assumptions on information. We also review some related literature.information heterogeneity; learning; infrequent decisions