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Technology
Department of Economics
Working Paper Series
Massachusetts
A
Institute of
"Verticar'Analysis of Crises and Intervention:
Fear of Floating and |x-Ante Problems
Ricardo
J.
Caballero
Arvind Krishnamurthy
Working Paper
01 -25
Julys, 2001
Room
E52-251
50 Memorial Drive
Cambridge, MA 02142
paper can be downloaded without charge fronn the
Social Science Research Network Paper Collection at
http://papers.ssrn. conn/paper.taf?abstract id= 276673
This
MASSACHUSEHS
INSTITUTE
OF TECHNOLOGY
AUG 1
5 2001
LIBRARIES
Massachusetts Institute of Technology
Departnnent of Economics
Working Paper Series
A
"Verticar'Analysis of Crises and Intervention:
Fear of Floating and Ex-Ante Problems
Ricardo
J.
Caballero
Arvind Krishnamurthy
Working Paper
01 -25
Julys, 2001
Room
E52-251
50 Memorial Drive
Cambridge, MA 02142
paper can be downloaded without charge from the
Social Science Research Network Paper Collection at
This
http://papers.ssrn.com/paper.taf2abstract id= 276673
Technology
Department of Economics
Working Paper Series
Massachusetts
A
Institute of
"Vertlcar'Analysis of Crises and Intervention:
Fear of Floating and Ex-Ante Problems
Ricardo
Caballero
J.
Arvind Krishnamurthy
Working Paper 01 -25
July
Room
5,
2001
E52-251
50 Memorial Drive
Cambridge, MA 021 42
paper can be downloaded without charge from the
Social Science Research Network Paper Collection at
http://papers.ssrn Com/paper.taf?abstract id=xxxxxx
This
A
"Vertical" Analysis of Crises
and
Intervention:
Fear of Floating and Ex-ante Problems
Ricardo
J.
Arvind Krishnamurthy*
Caballero
This
draft: July 05,
2001
Abstract
Emerging economies are prone
crises,
choice
to crises triggered
by external shocks. During these
should the central bank stabilize the currency or domestic interest rates?
We
argue that these questions are best analyzed in a "vertical"
framework, where the supply of external funds faced by the country
and monetary policy
crisis
This
liquidity.
elastic at the
is in
affects
(now higher) international
crisis
This asymmetry naturally
However, while
has negative ex-ante consequences as
it
this response is ex-post
exacerbates the structiually
insufficient private sector incentives to insure against crises. Ex-ante, optimal
is
countercyclical,
and increasingly so as
lining for countries with limited financial
come
this conservative-central-bank
role of
monetary policy
financial
development
development that cannot
time inconsistency problem,
in the vertical view
is
one of incentives,
(or
Keywords:
EO, E4, E5, FO, F3, F4,
well as
The
it
silver
should not) over-
main
can be substituted
crises.
Gl
External shocks, domestic and international liquidity, monetary policy,
interest parity departures,
'Respectively:
falls.
monetary
that since the
is
by ex-ante measures to induce the private sector to insure against
JEL Codes:
is
has relatively limited output consequences, while
leads to the widely observed fear of floating.
it
inelastic during
In this vertical view, raising
interest rate.
not doing so causes a sharp exchange rate overshooting.
rationalizable,
is
mostly the domestic cost of scarce international
contrast to the standard "horizontal" framework where supply
domestic interest rates during a
policy
the
outside the central bank's control, as in a currency board, are there good
is
policy substitutes?
the
If
exchange rate systems, overshooting.
MIT and NBER;
seminar participants
at
Northwestern University.
We
Brown and MIT. Caballero thanks
thank Raghu Rajan
the
NSF
caball@mit.edu, a-krishnamurthy@nwu.edu. First draft: April 11, 2001.
for financial
for
comments,
as
support. E-mails:
Introduction
1
Emerging economies are prone to
crises triggered
should the central bank stabilize the value of
choice
its
by external shocks. During these
crises,
currency or domestic interest rates?
the
If
outside the central bank's control, as in a currency board, are there good policy
is
substitutes?
Uniformly, the analysis of these questions begins by describing the external shock as an
upward
shift in
interest rate.
the interest parity condition: a rise in the country-premium or international
We
depart at the outset and argue that
for
most emerging economies,
this
"horizontal" approximation of the external supply of funds (unlimited funds available at a
high and fixed price)
this view, that
is
misleading for the questions at hand.
an emerging economy mired
in
an external
The
crisis
proposition, implicit in
could attract capital flows
by adopting an expansionary monetary pohcy, seems counterfactual
Instead,
elastic
what
during the
context,
is
needed
at best.
a 'Vertical" approximation, where the supply of funds
is
is in-
the country faces an international liquidity constraint. In this
crisis as
monetary policy predominantly
affects the
domestic cost of the scarce international
Expansionary monetary policy brings about a sharp overshooting in the exchange
liquidity.
rate depreciation, without any substantial gain in terms of real activity. In contrast, con-
monetary policy
servative
A
modern
central
stabilizes the
bank concerned with
by tightening during the
crisis.
observed "fear of floating"
The
exchange
rate,
its inflation
vertical
among emerging
with
little
additional output loss.
target will respond to this
view thereby accounts natturally
for the
it
during external
of
crises.
we show that
if
the central bank could
should in most circumstances pledge expansionary policy
Importantly, the optimality of the latter stems not from the impact
monetary pohcy during a
efi"ect
it
crisis, it is
exacerbates the structural underinsurance problem
that a- icts emerging economies. Quite the contrary,
conamit to a monetary policy,
widely
economies.
While a contractionary monetary policy may appear as optimal during the
not from an ex-ante perspective as
asymmetry
as the standard argument has
crisis,
it,
but from the ex-ante
the policy has on the incentive to insure against episodes of international liquidity
scarcity.
When
demand
firms in need of international resources face domestic financial constraints, their
for international liquidity is constrained as well.
financial constraints generate
'See
Calvoand Reinhart
a wedge between the marginal value of the international
(2000) and
among emerging economies with
In equilibrium, these domestic
Hausmann
flexible
et al (2001) for extensive
exchange rate regimes.
re-
documentation of fear of floating
and the market price
sources to the domestic firms
of these resources.
This underpricing
reduces the private sector's incentive to carry international hquidity into crisis-states and
hence insure against
crises (see
CabaJlero and Krishnamurthy (2001a)). Expansionary mon-
etary pohcy, while not directly alleviating the international financial constraint
constraint during an external crisis
— increases domestic
reward of maintaining international
monetary policy is to
The time
liquidity.
Thus
liquidity
—the main
and hence the private
in the vertical view, the only role of
affect the private sector's incentives to
manage
international liquidity.
consistency problem that arises in the vertical context, coupled with the in-
stitutional conservatism of
monetary policy
will
modern independent
central banks, suggests that in practice
be rarely used for incentive purposes. This bias increases the underin-
surance problem, in particular in those economies with more limited financial development
(i.e.
where firms
face tighter financial constraints).
The
that there are substitutes for the international liquidity
is
policy.
Since the primitive problem
is
economies
silver lining for these
management
role of
monetary
one of underinsurance, either direct or indirect ex-
ante measures that induce the economy to carry more international liquidity into crises
states reduce the underinsurance problem.
management,
all
For example, an active international reserve
capital controls, or procyclical international liquidity ratio requirements, can
substitute for monetary policy. Conversely, a credible
monetary policy during
crises is
commitment to a
countercyclical
a good substitute for costly capital controls and ex-ante
measures.
The
distinction
we draw between
international and domestic liquidity, coupled with the
association of monetary policy to the latter, also offers a different perspective on several
sues related to liquidity policy within different exchange rate regimes.
The
policy in a currency board or other inflexible exchange rate systems,
ically, is
not a serious impediment during
crises.
binding international financial constraint and thus
currency board
during a
is
instead due to the perverse ex-ante
crisis generates;
As
before, these can
largely irrelevant.
eff'ects
monetary
somewhat paradox-
Monetary policy does
is
loss of
is-
little
to relax the
The problem with
a
that the lack of credit expansion
be handled with ex-ante measures.^ Within
our perspective, international contingent credit lines are desirable regardless of the exchange
rate regime, and thus should not be thought of as a substitute for domestic
icy in a dollarized economy.
^Our analysis
is
meant to
They
monetary
pol-
are primarily about relaxing international rather than
isolate the liquidity
and
financial
market aspects of monetary
policy.
In so
doing, we eliminate the important but better understood goods-labor markets dimensions of monetary and
exchange rate
in
policy. All
the conclusion.
our remarks must be understood
in this
context.
We
briefly return to these issues
domestic financial constraints, and
flexible
and
it is
the latter rather than the former that differentiates
exchange rate regimes from a liquidity management perspective.^
fixed
Section 2 presents the basic model and highlights the differences between the tradi-
and the
tional horizontal
Our model
rate overshooting and the related fear of floating.
clear distinction
The
vertical
emergence of exchange
vertical analyses, including the natural
between two forms of liquidity
designed to establish a
is
international
(collateral):
view highlights the fact that during external crises
it
is
and domestic.
the former that
is
—such as monetary policy— cannot have
binding and hence measures to relax the latter
a significant immediate impact. The horizontal perspective, on the other hand, draws no
distinction between these
Section 3 asks
two forms
of liquidity.
how ex-ante private
icy measures and, in turn,
how
sector financing decisions are affected by ex-post pol-
answer leads to the design of optimal
this
policies.
We show
that domestic financial underdevelopment implies that in equilibrium the private sector undervalues international liquidity and insurance.
monetary policy reduces the extent
A credible
commitment to a
While
of this undervaluation.
this
countercyclical
would appear to be
a damaging criticism of dollarized regimes, we argue that this need not be the case since
the primitive problem
is
one of distorted incentives rather than one of
insufficient
and the former can be resolved by alternative means.
liquidity,
Section 4 summarizes our message in the context of a standard political
sion of rules-versus-discretion.
We
show that while
if it
is
less
all possible,
commitment
conservative than
it
Section 5 concludes and
proofe of our
between
discusis
a
the vertical perspective
inflexibility, in
neither an inflation bias nor an advantage of ex-post flexibility. Quite the contrary,
were at
to be
economy
in the horizontal perspective there
standard tension between inflation bias and ex-post
there
domestic
main
financial
will
is
propositions.
be
in the vertical region
be during a
crisis.
by two appendices.
The
inclined to
followed
would require the central bank
The second one
is
more
substantive.
market development and international liquidity
the main text, the monetary channel
we superimpose on
it
is
is
first
one contains the
While the interaction
explicitly
reduced-form.
modeled
in
The second
appendix sketches a debt-deflation model of this monetary channel.
See the recent work by
Diamond and Rajan
(2001) for a related perspective on financial crises based
on two potentially binding constraints: a solvency and a
liquidity constraint.
Their analysis focuses on the
ex-post effect of interventions during crises and, in particular, on the perils of pohcies that
the binding constraint during the
crisis.
fail
to identify
The
2
Vertical
we describe the environment and
In this section
and
View and the Fear
vertical views of crises.
vertical
We
of Floating
discuss the difference between horizontal
show that when domestic
financiaJ markets are illiquid, the
view imphes that the exchange rate overshoots in response
to
monetary pohcy and
central banks are naturally led to adopt a fear of floating strategy.
Basic setup
2.1
We
study an economy exposed to an external financial
country's risk-adjusted international cost of
is
followed by a final date 2
with a date
0,
which
is
when
a fully
period
when
make
agents
and precautionary decisions. The periods are indexed by
f
=
rise
occurs at date
crisis
We
repay their outstanding debts.
firms'
flexible
The
capital.''
by the
triggered
crisis,
of the
and
1,
start
time
investment, financing,
0,1,2,
and there
a single
is
(tradeable) good.
There
in the
form
foreigners
rate Iq
of receivables arriving at date
(e.g.,
and
w
a unit measure of domestic firms, each endowed with
is
i|
These date 2 goods have
2.
prime exports), who axe willing to lend against
from period
to
1,
and
1
units of collateral,
collateral value to
and
at dates
it
to 2, respectively. Foreigners play
1 at
no other
the
role in
our model.
Domestic firms also have access to a production technology. Building a plant of size k at
date
requires
them
to invest
c(fc)
— with
>
c{.)
0, cf
>
and
2 output proportional to the size of the plant (see below).
resources at date
0,
The
expected plant profits at date
2.
financing
Since domestic firms have no
and investment decisions
To keep matters simple, we
run by a domestic entrepreneur/ manager who has
consumption
— which yields date
>
they must import the capital goods and borrow from foreigners,
to finance this investment.
is
c"
shall
axe taken to
maximize
assume that each firm
risk neutral preferences over
date 2
their expected
output
of the single good.
Firms face significant financial constraints. Neither the plants nor
axe valued as collateral
by
foreigners.
When
real investments are undertaken, firms
a part of their international collateral in securing foreign funds. All financing
fully collateralized
debt contracts, thus, do,/
^
is
mortgage
done via
^•
'Nearly the same analysis applies to a sharp decline
binding.
do,/,
in
terms of trade that makes
financial constraints
Date
2.2
For the remainder of the section,
We
focus on the crisis period.
lending rate,
2|
let
Crises
us take as given
all
date
define a crisis as an event in
decisions
which a
how
financial constraints
— k and
rise in
causes financial constraints to bind for firms. Let us
,
the financing need and explaining
In our
and
financing needs
1
to defining
to bind.
economy the financing need stems from the normal ongoing maintenance of the
productive structure.
We
capture this feature by simply assuming that the plants of one-
from
half of the firms receive a production shock at date 1 that lowers output per plant
to a. This productivity decline can be
2 output
oflFset
by reinvesting 9k {9
We assume
say that a
crisis
occurs
A— 1 > i^.
if
much
as possible to finance reinvestment.
firms are curtailed in their date
If this is
shock, the firm
first
borrows against
its
is
from foreigners. After
this, it
their
fi-om foreigners
vP
if
Our
said to be distressed.
is
To cope with the
=
10
— do J
must turn
to the domestic firms that did not receive
1 either,
so they
they are to finance the distressed firms. This they can do
of financial slack.
But why would
intact firms lend to distressed firms
assume that domestics value as
either,
any more than foreigners?
collateral the firm's installed assets as well.
a perfectly functioning domestic financial market
economy
1.
the case in equilibrium (see the appendix).
a shock ("intact firms") for funds. Intact firms have no output at date
must borrow
shall
<1, despite the
reinvestment, 9
1
We
net international collateral:
u;"
up to
A—1 >
the case, then firms are financially constrained at date
firm that receives an idiosyncratic shock
directly
goods, to give date
A=A-a.
where
assumptions on parameters are such that this
A
1)
that the return on reinvestment exceeds the international interest rate:
This means that firms will borrow as
fact that
<
A
of,
A{9)k={a + 9A)k<Ak,
zj.
— and
the international
now turn
may come
do,/
and this departure has
is
We
However, since
hardly a good description of an emerging
central implications for our analysis,
we assume that
only a fraction of the output from domestic investment can be pledged to other domestics.
It will
simplify the formulae, without loss of insight, to
make
output: Xak. Since firms can use this collateral to borrow
Xak
as domestic liquidity.^ Likewise, since at date
"Since we do not want insurance markets to
is
up to
this
minimum
amount, we
refer to
firms can borrow from foreigners
undo the ex-post
shocks are non-observable and non-contractible. Moreover,
pooling equihbrium
1
this a fraction of
heterogeneity,
we assume
up to
we assume that idiosyncratic
that the coordination-fragile ex-ante
not feasible (see Caballero and Krishnamurthy (2001b)).
we
w"' of international collateral,
refer to u;" as the international liquidity
After pledging u;" to foreigners, distressed firms pledge their
who
Xak
during the
to intact domestics,
in turn pledge their ty" to foreigners to access foreign funds. All direct
foreigners
is
done at the
interest rate of
crisis.
borrowing from
i|.
The (standard) Horizontal VieAv
2.3
In the standard horizontal view, distressed firms are constrained in meeting their financing
They have
needs only to the extent that they have limited collateral.
Xak
+ w'^
which they borrow against
at the interest rate of
total collateral of
i^.
Translated into our context, the horizontal view implicitly assumes that the country as
a whole, at the margin, has an international liquidity slack. In other words, a foreigner
would be willing to extend another loan at
firms have limited collateral,
it
is
to some domestic firm.
happens that the worthy firm
In our model, since intact firms borrow
firms against Xak, there
i|
is
|to"
>
since distressed
not distressed.
from foreigners against
excess international liquidity
But
xv"
and lend
to distressed
if,
^Xak.
(1)
Since intact firms are not saturating their international financial constraint, the interest rate
they charge on the loan to a distressed firm, against domestic collateral of Xak,
is
simply
determined by the arbitrage condition:
-
Total reinvestment
is
^i
=
il
then determined by the individual firms' financial constraints:
,,,^rul±X^^2^^^
^''<1,
(2)
where the superscript h denotes the horizontal equilibrium. The inequality in the main
expression reflects that the economy has not used
indicates that the
economy
is
all its
international liquidity, while 6^
in a crisis: distressed firms are
unable to meet
all
<
I
financing
needs because of the binding financial constraint.
We
refer to this as the horizontal view,
the quantity of them.
interest rate
^|,
A
is
not affected by
distressed firm could in principle continue borrowing at the given
as long as
an experiment where A
because the price of loans
is
its
domestic financial constraint
raised slightly,
leading to increased loans at
ij
we would
is
if
we imagine
relax the domestic collateral constraint,
and increased reinvestment.
after introducing the vertical view.
relaxed. Thus,
We
return to this discussion
2.4
The
Vertical
View
In this view, the international supply of funds that
external crises
is
vertical -
faced by emerging economies during
The country has enough domestic
inelastic.^
i.e.
is
collateral to
aggregate the international liquidity available to agents in the economy, so that inequality
11
(1) is reversed:
< -Xak.
-u;"
However, there
of the
is
insufficient international liquidity in the
economy's needs so that the economy
- >
2
When
is still
i|
(see the
for all
in a crisis:
1+iJ
on loans against domestic
the above conditions hold, the interest rate
departs from
aggregate to raise finance
collateral
appendix for restrictions on primitives). Since intact firms, and not
foreigners, accept as collateral the Xak,
and
intact firms are borrowing
up
to their
maximum
capacity from foreigners and lending to distressed firms, the domestic price of a dollar-loan,
if, rises
above
z|:
ii>ii.
Importantly, the fact that the international liquidity constraint
does not
mean that the domestic
collateral
is
binding at the margin
problems that dominate the horizontal approach
disappear. This observation will be central in understanding the desirability
monetary
policy.
As we show below,
as long as domestic firms continue to
strained, the domestic (dollar) interest rate
is less
and impact of
be credit con-
than the marginal product of investment
for the distressed firm:
if<A-l.
This
is
collateral,
the rate at date
and
is
1
on a one-period domestic loan against a unit of domestic
both the dollar cost of capital for firms in need of funds, as well as the
expected return on loans
for
collateral of distressed firms
domestic lenders.
and the amount of international liquidity of intact ones. The
aggregate collateral of distressed firms
intact firms in exchange for date
there
is
determined by both, the amount of
It is
1
is
Xak/2. Thus they pledge Xak/2 of date 2 goods to
goods of w"/2.
If
domestic collateral
is
not too limited,
a scarcity price for the international hquidity, and the price needed to clear the
domestic loan market,
if,
will
exceed the international interest rate,
^ak
d
'^
W^/{l+il]
"See Caballero and Krishnamurthy (2001a).
l>tl
i*:
(3)
This expression highlights the effect of domestic collateral and international liquidity on
date
1 cost of capital.
A
shortage of the latter
former means that the cost of capital
investment at date
1
(A):
ij
< A—
means that
will generally
be
if
less
>
zj;
while a shortage of the
than the marginal product of
1.
In other words, in the aggregate, a shortage of international liquidity yields a spread
between domestic marginal product and international cost of
on the other hand, determines the sharing of
this
capital.
Domestic
collateral,
spread between domestic lenders and
borrowers of a marginal dollar.
In this region, domestic collateral plays no role in determining aggregate reinvestment.
In equilibrium,
all
international liquidity
is
e^k
where the superscript v stands
2.5
Date
i
1
monetary
aggregated, so that reinvestment
=
is:
2t(;"
(4)
1+iV
for vertical equilibrium.
policy, overshooting,
and
fear of floating
d
w"/(l+i,*)
Figure
As an introduction
1
:
Vertical and Horizontal Supply
to our discussion of
monetary
policy, the
main
distinction between
the vertical and horizontal views can be seen by considering the experiment of increasing
8
collateral) by
A (boosting domestic
On
a small amount.
1
illustrates this diflFerence.
the vertical axis we measure the domestic dollar-interest rate on loans against domestic
On
collateral.
the horizontal axis
we capture domestic
represent efTective (collateralized) loan
the supply
is
horizontal {d)
Note that
in
and
demand from
distressed firms in regions
the horizontal case a shift in
an increase in
where
vertical {d').
demand
(say
by increasing A)
investment, while leaving the domestic price of loans unaffected.
vertical region,
The
loans or domestic reinvestment.
supply of loans from intact firms, d and
solid flat-and- then- vertical curve correspond to the
d'
Figure
On
raises date 1
the other hand, in the
has no effect on equilibrium investment, and instead only
d'
pushes up the domestic interest rate of
if.
Let us take a reduced form approach to monetary policy whereby the central bank can
indeed affect A (see the appendix for an explicit model of this channel).
chooses a combination of peso-interest rates,
by the (domestic)
The
and expected appreciations,
ij,
(61
central
bank
— 62), traced
interest parity condition:^
ii=^? + (ei-l),
where A can be written
as A(z^, ej),
and without
Most models with a monetary channel
models and scenarios.
domestic collateral by raising
we
will take the
liabilities
(i.e.,
<
0,
latter
we have
set 62
=
1.
while the sign of Agj varies across
is
positive, or not too negative,
a reduction in domestic peso-rates) also expands
A.
above configuration as our reference case, although in the conclusion
discuss briefly the case of Ae
domestic
yield Ajp
However, as long as the
an expansionary monetary pohcy
We
loss of generality,
—
as this
is
«
—^perhaps
capturing an extensive dollarization of
one of the main reasons given
in the literature to prefer
constrained monetary regimes over more flexible monetary arrangements.^ It
to notice, nonetheless, that our main argument
is
is
important
very distinct from the issues raised in this
debate.
The
tradeoff of the
in this context.
(increases A),
An
monetary authority
in the horizontal perspective
expansionary monetary policy relaxes the domestic financial constraint
and by doing
so
it
increases investment (see (2)):
de^k
ak
dX ~
'By domestic
can be understood
interest parity condition
we mean
l
+
il'
the relationship between the return on peso and dollar
instruments backed by domestic collateral. See appendix A3.
^See,
e.g.,
Aghionetal (2000), Gertleretal. (2001), Cespedes
et
al.
(2000), and Christiano et
al.
(2000).}
The standard
tradeoff
is
that this investment increase must be weighed against the
inflationary costs brought about
In the midst of a
by the monetary expansion and exchange
and within a reasonable range, the
crisis,
dominated by the output gains of the expansionary
Our main
and
opposed to the domestic
and output
from noticing that the weights
in the vertical region.
closely related reasons. First, since the
latter costs are likely to
be
policy.^
results in this section follow directly
above tradeoff change abruptly
rate depreciation.
This happens
main binding constraint
is
for
in the
two important
the international as
collateral constraint, relaxing the latter does not affect reinvestment
(see (4)):
86" k
-^ =
Second, while
all
choices of i^
and
'-
ei that leave the
the same real investment decisions, they do not
from
(3)
we
see that
ii
is
same
asset prices. In fact,
ak
d\
difference
lead to the
in the vertical region yield
increasing in A:
dii
Thus a key
all
economy
+
u;"/(l
from the horizontal region
ij)'
is
that
an increase
in the (domestically determined) interest parity condition.
That
is,
in
A results
in
a
shift
in the vertical region
there are two effects of an expansionary monetary policy on the exchange rate that need to
be considered. There
is
the standard interest parity effect: Fixing if
if
+
ei
-
1
=
if
>
in,
ii,
the exchange rate weakens by the same amount as the peso-interest rate
this
new
point, A rises as well. Since if
is
interest parity condition shifts upwards,
amount. We
refer to this
phenomenon
is
lowered. But at
increasing in domestic collateral, the (domestic)
and the exchange rate depreciates by a
larger
as exchange rate overshooting because, relative to the
horizontal region, in the vertical region peso-interest rate reductions lead to proportionately
larger depreciations in the exchange rate.
With
little
direct real consequences,
dictated by secondary considerations
fear of floating to be an example of
date
1
from the shock to
i\.
1,
in the vertical region
(e.g., inflation targets).
this.
At date
monetary policy
We
The central bank wishes
may be
take the widely observed
to protect the exchange at
the output costs to raising interest rates are minimal
'in this sense, the monetary policy problem with financial frictions in the horizontal perspective
different
from the standard closed economy problem applied to developed economies as
Gertlerand Gilchrist (2000).
10
in, e.g.,
is
no
Bernanke,
(beyond the direct costs of the external shock), and instead the action has a substantial
on the exchange
effect
= Zj,
the point where if
Does
this
making
icy,
rate.
The
logical conclusion
is
to raise interest rates, lowering A to
and thereby defending the exchange
rate.
that emerging economies should abandon countercyclical monetary pol-
mean
explicit
what they have de-facto adopted through
their fear of floating?
This
is
one of the main questions we turn to in the next section.
Optimal Policy Regime: The menu of date 0/date
3
mea-
1
sures
In the vertical view, international hquidity and hence the supply of external resources to the
country
is
agent, can
Date
predetermined during a
do to
to
more
on the other hand, can
we show that
efficient
date
monetary
This section
We
affect
is
nothing that a central banJk, or private
the date
1
external position of the country.
the anticipation of an expansionary date
private sector decisions.
- as in a currency board?
loss of
There
alter this reality.
actions,
In particular,
crisis.
We
But what
if
1
monetary policy leads
monetary policy
is
constrained
measures can substitute
argue that exphcit date
for
the
policy.
ofi^ers
a menu of date 0/date
1 policies
that are optimally taken together.
show that the conclusions one draws regarding optimal policy and the choice of
also
exchange rate regimes hinges crucially on separately identifying domestic and international
liquidity.
Structural Underinsurance
3.1
and Optimal Monetary Policy Commit-
ment
Let us
date
1
revisit
the private sector's date
investment and financing decisions, taking the
policy of the central bank as given. Moreover,
let
us for
now summarize
bank's policy by the value A takes, and disregard any decision that
specific
that date
is,
arise
from the
combination of (ii,ei) that achieves this A.
To make our
that
may
the central
1
the
points,
we do not depend on
the presence of aggregate shocks.
We
aggregate conditions are fully anticipated to be those of an external
economy
will
be
in the vertical region,
assume
crisis
—
with binding financial constraints (see
the appendix for parameter conditions to arrive at this scenario).
Let us consider firms' incentives to precaution against the date
11
1 crisis
and, particularly,
how
these incentives are aifected by the domestic cost of capital,
ante decision to reduce date
the date
Precautioning
is
an
ex-
investment, borrow less of doj and save this debt capacity for
Equivalently this
1 crisis.
if.
is
a date
some
private decision to hoard
international
liquidity.
The net return on
On
pieces.
-I-
goods
at date
is
2.
composed
On
of
two
the cost side,
which would have yielded a return
io)c'(^) units of international liquidity
the domestic financial market at date
if in
Ak
the gross return side, the firm obtains
sacrifices (1
it
investing an extra unit of k for an intact firm
Thus, at the margin increasing k yields an
1.
ex-post return, net of opportunity cost, of
A-c/{k){l
It follows
edness
is
immediately from
+
ii){l
is
(5)
i*o).
that the opportunity cost of increasing date
(5)
undervalued by an intact firm as long as
external funds
+
if
<
A—
1.
Since the
1 is
for
date
1
constrained by the distressed firms' limited domestic collateral, the value
of holding on to a unit of international liquidity in order to supply
date
demand
indebt-
depressed relative to the socially
efficient
it
to distressed firms at
— and the distressed firm's — valuation,
A.
Now
goods can be pledged as
collateral in the
domestic loan market at date
be multiplied by the private return that each generates
loan secured by Xa goods at date
2,
cost side,
which yield a private return of
A
investment in k yields a net return
a ({1
It
it
-
(its
Thus
1,
that firaction must
A
value as a collateral asset).
generates proceeds of
each can be reinvested at a gross return of A.
— A)a-f- Aa—^. On the
the gross return side, at
But because a fraction A of these
the margin the firm obtains a unit of goods directly.
(1
On
consider the same net return for a distressed firm.
7^
goods at date
1,
which
the gross benefit to increasing k
is
sacrifices (l-l-iQ)c'(A;) units of international liquidity
to a distressed firm.
Thus, at the margin increasing
of:
A)
+
Ay^)
- c'(fc)A(l + z5).
(6)
follows immediately from (6) that while the cost of sacrificing a unit of international
liquidity
A-
is
properly valued by a distressed firm, the domestic investment
1,
a distressed firm
if
<
its
overvalued domestic collateral.
an external
crisis
is
able to keep
some
is
not.
As long
as
of the surplus from reinvestment by selling
A central planner,
on the other hand, realizes that during
only international liquidity generates social surplus, and hence discounts
domestic assets at
A
rather than (1
'"Since the analysis above takes date
+ if)}^
decisions as given, the expected return
12
on domestic loans
splits the
Although
for different reasons,
both intact and distressed firms overvalue (from a
point of view) domestic investment relative to
its
opportunity cost
— namely
cost in terms of the international liquidity used. Since the ex-ante decision
average of these two outcomes,
precaution for the date
1
based on the
and under-
shock. ^^
is
an equilibrium problem.
only in the vertical
It arises
region, as the supply of international funds faced by distressed firms
others' actions in the horizontal region,
and
it
policy
now. Since increasing A at date
commitment
1
so that zf
is
increases if
to ex-post
<A—
independent of
1.
in the vertical region should
be apparent by
and reduces the spread between
the distortion caused by limited domestic collateral
monetary policy commitment
is
stems from distorted asset prices due to
- limited Xak constrains demand
The optimal monetary
if,
is
opportunity
follows that firms will overinvest, overborrow
it
The over-borrowing problem
financial constraints
its
social
falls
as A
during the
(i.e.,
1
and
Thus the optimal
rises.
crisis)
A—
choose the
maximum
possible A.^^
Aside from the standard inflationary concerns associated to the need for a very active
monetary
between ex-ante (countercyclical) and ex-post (pro-cyclical)
policy, the contrast
optimal policy during crises highlights an unusual commitment problem.
The
central
bank
should certainly commit to not "fear floating," but should ideally commit to exacerbate
the exchange rate depreciation during a
—
its
crisis.
not credible, the incentive benefit
If this is
— of coimtercyclical monetary policy vanishes and
only benefit in the vertical world
the cure for the structural underinsurance problem must be sought elsewhere.
We
return
to such an alternative after introducing constrained monetary regimes.
reinvestment surplus,
A—
1,
between domestic lenders and borrowers but
the economy. Total reinvestment
is,
the
sum
fully
is
does not affect the real side of
determined by the total availability of international liquidity (that
of the international collateral available to distressed
(1
it
+ i;)^ek = ^{w -
do,/)
and intact
firms):
+ ^{w-chj),
to imply (in a crisis):
(1
This dichotomy between the
ment and
portfolio decisions.
one. In particular,
It is this
it
gives
real
and
When
is
il)k
a domestic decides to
up some of
financial decision that
-I-
financial side disappears at date 0,
its
make a
investment,
it
also
their invest-
makes a
financial
international liquidity, w, in exchange for domestic collateral, Xak.
affected by if.
This opens the door to international liquidity management
namurthy (2000a). See
real
when domestics make
also Harberger (1985)
policies, as
and Aizenman (1989),
we study
for alternative
in Caballero
and Krish-
models of over-borrowing
based on the undervaluation of the country's monopsony power in international financial markets.
See the appendix for a formal proposition and proof of this result.
13
Constrained Monetary Regimes
3.2
One
is
main
of the
criticisms of doUarization
that the central bank
criticism
would appear to be
all
the more damaging
value at the time of a vertical
Under the
fixed
exchange rate systems
unable to implement countercyclical monetary
is
are appended to standard arguments.^''
little
and other hard
when
policy.
financial accelerator
As we have argued, however,
This
mechanisms
this policy option has
crisis.
vertical view, the concern
with these type of exchange rate regimes
is
close
to that of the free insurance criticism of fixed exchange rate systems, whereby the latter
is
perceived as a central bank subsidy on dollar-borrowing.^'^
However
derinsurance does not stem from the fixed value of the exchange rate
central bank's inability to optimally
expand A during
crises
our model un-
in
itself,
and reward
but from the
the hoarding of
scarce international liquidity. Thus, for example even in a flexible exchange rate system,
policy
is
not sufficiently counter-cyclical, there
There
is
policy options emerges.
crises,
problem
be the underinsurance problem.
a "silver-lining" for constrained monetary regimes in the above discussion.
the problem of doUarization
during
will
is
shifted from
an
ex- post to
an ex-ante distortion, a new
Rather than seeking hard-to-find substitutes
that
directly.
A — (1 + ii)
may
set of
monetary policy
^^
take
commit to expand
credit at date
remains high, and thus the return to hoarding international hquidity
until date 1 remains undervalued.
liquidity
for
As
the policymaker can introduce measures to solve the ex-ante underinsurance
Recall that the problem induced by not being able to
1 is
if
many
While
in practice this undervaluation of international
forms, in our simple
do,/) or, equivalently, excessive investment in
model
it is
just high external leverage (high
domestic firms (high k)}^
In our environ-
ment, there are two obvious ex-ante policy measures that can deal with the underinsurance
problem: capital inflows taxation during normal times (date
requirements at date
e.g.,
Gertler et
and international
liquidity
0.
These ex-ante options, of comse, are also available
"See,
0),
al
in a flexible
exchange rate system.
(2001) and Cespedes et al (2001).
'•See.e.g., Dooley (1999).
'^Note, however, that even hard currency board systems can effectively implement some degree of monetary
policy by,
e.g.,
temporarily allowing domestic Treasury instruments denominated
in
dollars to count as
international reserves, or relaxing the banks international liquidity ratios, as Argentina has done over the
last decade.
'*With a
slightly richer
model,
in
Caballero and Krishnamurthy (2000a, 2000b) we show that this un-
dervaluation also leads to increased doUarization of
contingent
liabilities,
lines.
14
increased short term debt, and insufficient
To
the extent that A cannot
at date 1 in order to align the date
move sufficiently
of the central planner and private sector, perhaps as a result of the
More
discussed earlier, these measures are desirable.
of the previous subsection
tax and
commitment problems
generally, let us return to the analysis
and characterize the relationship between the optimal ex-ante
A.
At the aggregate
of
problems
'^. The
level,
building a marginally larger plant always generates date 2 output
opportunity cost of doing this
1
at which point, since
is
cf{k){l
+ io)A.
is
to save this internationalliquidity until date
one of the distressed or intact firms
In total, the social return
will
be reinvesting, the return
is,
^-c'{k){l+i*o)A.
private and social incentives
Aligning the date
Suppose that the central bank
policy.
in a
lump sum
fashion.
Then, from
of international Hquidity as
where
if^.
represents the
As we concluded
policy
r
=
is
levies
(6)
and
a matter of choosing a tax/transfer
a tax r per unit of
(5),
is
no reason
zi
= A — 1,
A
clearly decreasing with respect to
^fr
and
all
We
is
(7)
and
(8) coincide for
not the case, the optimal
few steps of algebra, and identifying the social
planner's quantities with a hat, gives us that the optimal tax
is
returned to firms
a domestic dollar-loan.
for intervention at date 0. If that
tax must equate these two expressions.
which
is
domestic financial markets are well developed or monetary
powerful enough so that in the absence of taxes
and there
which
it, is:
(after taxes) equilibrium cost of
earlier, if
k,
the private sector return to hoarding a unit
opposed to investing
new
is
(7)
A
is:
since:
-
ak
A
the social planner's quantities are independent of A.
think of the above as an "iso-internationaJ Hquidity" menu: a schedule of
(r, A)
such
that the private sector and social incentives are aligned. Thus, for example, in the case of
a A that cannot respond to external shocks, as
T would be
beneficial.
15
is
the case of a dollarized system, a positive
Of course,
come with
in practice taxes
their
own
of taxation, costs of enforcement, evasion, etc.
measures
date
in our
model
is
that
if
international liquidity will
1
sector hoard liquidity.
— deadweight costs
sets of distortions
Moreover, a significant drawback of date
they are not fully reversed at date
more than undo the date
1
the reduction in
,
benefit of having the private
Thus these measures do require the authority to be very responsive
to economic conditions.
These
active
along with the credibility (see above) and inflationary problems of an
issues,
monetary
policy,
need to be weighed
monetary policy arrangement
in
to point out the existence of a
exchange rate system
is
a
in deciding
of options.
the optimal exchange and
in this section
is
In contrast to prevailing views, a fixed
not strictly at a liquidity disadvantage to the flexible system. This
wisdom
contrast arises from the fact that the prevailing
perspective, while
is
Our main purpose
specific country.
menu
which
we argue that during
severe crisis
it is
based on a domestic liquidity
is
international rather than domestic
liquidity that matters the most.
International Credit Lines and Reserves
3.3
International credit lines are often perceived as a necessary supplement to constrained
monetary regimes. In a
vertical framework, however, these lines are desirable regardless
of the exchange rate regime,
and thus should not be thought
monetary policy in a dollarized economy. Since
a
in
crisis
the international one, any effort to loosen this constraint
is
of as a substitute for domestic
the main binding constraint
is
desirable.
Indeed, the usual view that credit lines are valuable in a currency board because they
allow for
of this.
some
ability to
expand
This argument makes
credit in crises
little
and prevent bank runs
sense in a horizontal view because,
country would simply borrow the dollars to expand banking credit in
be no need to have contracted ex-ante
view, the country
alleviate the
is
for
a credit
just a version
if it
crises.
magagement
There would
the other hand, in the vertical
crisis,
thus the only policy that can
problem are ex-ante measures to ease this constraint. ^'^ The same
to international reserves
could, the
On
line.
internationally constrained in a
is
logic applies
considerations.
'^International credit lines should in principle be contracted directly by the private sector, but the
underinsurance problem
will
do so
(see
we have
highlighted in the core of the paper will limit the extent to which they
Caballero and Krishnamurthy {2000a)
of capital inflows).
Of
course,
if
it
particular exchange rate arrangement in place,
lack of
for a related
argument
in
the context of a sterilization
the central bank or government has access to international contingent
instruments that the private sector does not,
domestic monetary
same
should use
eis it
it.
is justified
policy.
16
Again, however, this
is
true regardless of the
by the vertical constraint rather than by the
4
Political
Economy
In the standard discussion of rules versus discretion in monetary policy, there
between the inflation-bias costs and the ex-post
tal tension
and Gordon
(1977), Barro
Kydland and Prescott
(e.g.,
often extrapolated to the debate
on
fixed versus flexible
optimal system typically involves a central bank that
but that commits to do
In this section
fails
when
less
we show
smoothing than
it
(1983), Rogoff (1987)). This logic
exchange
an
that while this logic
is
is
reversed in this case.
In this context, the
with some ex-post discretion
is left
applicable in the horizontal region,
As we discussed
inflationary bias nor an ex-post
commitment problem
rates.
is
would be tempted to do ex-post. -^^
external crises are of the vertical type.
neither
is
a fundamen-
flexibility benefits of discretion
the vertical region the ex-post incentive for the central bank
there
is
is
it
in previous sections, in
to tighten excessively, so
smoothing advantage. In a sense, the
Partly as a result of institutional design to
prevent the traditional inflationary problem and partly due to the time inconsistency issue
we have
described, central banks are likely to behave too conservatively during crises. If so,
the exchange rate/ monetary policy combination
problem, and the solution
To analyze these
let
may have
issu^,
let
A now depend not on the
expected
rate fi^om
rates.
For
unlikely to solve the structural incentive
is
to be looked for
among
ex-ante measures.
us introduce two modifications to our basic model. First,
level of peso-interest rates
simplicity, let us also
make
but on the gap between actual and
this function linear
and drop the exchange
it:
A(2?
-
Eoi?)
=
A
-
77(2?
- Eoi?),
Second, suppose that the central bank objective at date
as well as meeting
its
inflation target.
A,
1
7?
>
covers both real investment, 9k,
For this purpose,
let
the gap between actual and
target inflation be proportional to the depreciation of the nominal exchange: (ei
let
—
1),
and
the central bank's objective be to maximize.
0fc-|(ei-l)2,
with
4.1
a >
0.
Horizontal region
At date
1
the central bank takes as given expected interest rates and maximizes:
max
The
w"
-I-
A(i?
H
-
— - —a,
Eoi?)afc
^
(ei
-
,o
l)"'
discussion of fixed with escape clauses, or flexible exchange rate systems with tight inflation targets,
and so on,
is
largely rooted in this view.
17
This yields as a
which
in the
order condition (where the superscript
first
absence of aggregate shocks
H denotes horizontal):
we
equal to the expected interest rate. Thus
is
obtain the standard inflation bias of the non-commitment solution:
eiWithout aggregate shocks there
date
1
since the latter
of real investment.
is fully
The
is
ak
1
V
= ---—:
a
1
+
>o.
zj
no advantage of keeping the option to devalue
at
anticipated and results on higher inflation but no expansion
role for discretion
comes from the presence of aggregate shocks
and the fact that the underlying contracts cannot
fully insure these
expected inflation that enters into the A expression
shocks away, so the
the unconditional rather than the
is
state contingent one.
Let us introduce aggregate shocks, so
international interest rate
The bad
needs.
state,
is
now
low enough that
there
all
is
a good state of the world where the
firms can fully finance their investment
on the other hand, leads the economy to be
in the constrained
horizontal region.
Starting firom the good state,
in terms of real activity
target. In the
rate
is
is
bad
state,
set as in (10).
The
is
apparent that since the central bank gains nothing
from lowering interest
rates,
it
on the other hand, the problem
The important
that the expected interest rate
reinvestment
it is
is
will set e^
is
difference with the
now
lower than
Zj
1 to
meet
its inflation
exactly as above, and the interest
full
,
certainty (as of date 0) case,
which means that A
enhanced by the expansionary ex-post monetary
latter establishes the
=
>
A,
and
policy.
standard tradeoff between the stabilization role of discre-
tionary monetary policy and the inflationary bias that such option generates.
4.2
Vertical
These tradeoffs change when the bad state of the world brings about a
At date
real
1,
vertical constraint.
regardless of whether this was fully anticipated or not, the central
reward
in lowering interest rates as reinvestment
be only concerned with
In this case, there
is
its inflation
no
target
and
set ei
inflation bias as there
is
no longer depends on
=
1
A.
bank
sees
Thus
it
no
will
in all states of the world.
no advantage of ex-post opportunistic
behavior by the central bank. Leaving the central bank with ex-post discretion does not
help smoothing real fluctuations.
18
—
Quite the contraiy, as we described above, the optimal commitment solution
the central bank to be expansionary during the bad state of the world even
have any ex-post reward.
but
by
in
exchange
for
it
If
such commitment
monetary
to force
that does not
then the inflationary bias re-emerges
incentives to precaution axe improved.
date
the ex-post impact of
exists,
if
is
policy, real fluctuations are
That
is,
rather than
smoothed by inducing the
private sector to do something about them.
In practice, however,
especially those
still
it is
aflFected
highly unlikely that a
modern independent
by the standard reputation
issues of
and
inflation
—
bank
central
prone past
will be willing to follow this countercyclical recipe very actively. If so fear of floating
,
must be
recognized as a positive statement on policy, in which case central bank discretion has
little
advantages and the exchange rate discussion becomes more or less moot from a liquidity
provision perspective.
The underinsurance problem has
to be resolved by ex-ante
means
such as the capital taxation of the previous section.
To summarize
this section, the standard debate of rules versus discretion,
and
its
appli-
cation to the exchange rate selection debate, applies to countries that are reasonably well
integrated to international flnancial markets {w large) and hence have crises that
the horizontal region.
fall
into
does not apply well to countries that are frequently affected by
It
sudden stops. Under the modern rules of independent central banking, with concerns
narrow
The
inflation targets, inflationary bias is not the
latter is problematic
because
itis
main concern but
fear of floating
for
is.
exacerbates the structural underinsurance problems
of these economies.
5
Final
Remarks
There are three main
a sudden-stop
crisis
insights highlighted
has hmited
while the main problem
ineffectiveness
is
will
First,
monetary policy during
real effects since it primarily aflects
domestic liquidity,
this real-
the large sensitivity of the exchange rate to monetary pohcy.
Fear of
is
from
this
asymmetry. Second, private sector decisions
tion of a sudden-stop crisis are affected
crisis.
analysis:
one of international hquidity shortages. The dual of
floating follows naturally
during the
by our
in anticipa-
by the expected actions of the monetary authority
In particular, anticipation of increased domestic liquidity during a crisis
induce the private sector to preserve more international liquidity for the eventual
Third, since the role of monetary policy in this context
is
crisis.
one of incentives rather than one
of (international) liquidity provision, loss of monetary discretion can be substituted for with
ex-ante measures that induce the private sector to save international liquidity for crises.
19
Of course
there are
many
caveats that a stylized model like ours
example, in practice expanding domestic liquidity during
neous positive
we have assumed that once
effects. Similarly,
We
expand international
liquidity.
to monetary policy.
The standard argument
when nominal wages
are sticky applies here as well
collateral
is
then a devaluation
may
Equally styhzed
many
can relax
this
is
have some contempora-
in a crisis, there are
assumption and even connect
if
much
if
is
dollarized,
crisis.
are either vertical or horizontal.
all crises
and external borrowing becomes gradually more expensive, be-
fore falling into a sharp vertical
in this context
is
the environment
may be around
what to do with monetary policy
is
still
A
sudden stop phase.
fairly horizontal
but there
central question for
pohcymakers
at the early stages of the crisis,
is
a
the corner. At this stage, tightening monetary policy destroys financially
jecture that this tradeoff can be analyzed in terms similar to those
commitment to an aggressive
to arrive
is
countercyclical
credible, then there is little
the commitment
is
need
we have used throughout:
during the horizontal phase. But
not credible or feasible, then the appropriate response
was advisable
in our simplified
of the additional financial distress
liquidity,
model
in
very
much
such case. In
to provide a policy
to tighten
the costs in terms
fact,
sector,
we already
recommendation but
is
as taxing capital flows
imposed upon the domestic private
extent comparable in nature to that of the ex-ante measures
Our goal has been not
We con-
monetary policy were the sudden stop
to tighten
during the early phase to protect international
at date
when
concern that a sudden stop
real
constrained projects but saves international liquidity for the potential sudden stop.
if
In
instances crises build up, going first through a horizontal phase, where domestic
financial conditions tighten
K the
directly
it
the prime companies of a country are in
reduce international collateral during the
our assumption that
no tools to
of the country's international
energy and telecommunications) and their debt
(e.g.
For
subject to.
that a devaluation helps the export sector
linked to export firms. Conversely,
the non-tradeable sector
crises will
is
is
to
a large
discussed.
to identify the nature of
the tradeoff involved and, in particular, to highhght the contrast between these tradeoffs
and those
identified in the traditional horizontal view.
Nevertheless, in closing,
for the question of
what
is
is
it
worth speculating on the relevance of our perspective
the optimal exchange rate system for emerging economies.
We
conjecture that for this purpose our distinctions are most relevant for an intermediate range
countries. In fact, for countries with a history of inflation problems, the gains of currency
boards probably outweigh the
costs. ^^
does not change the calculation.
"in addition
to those
we mention
in
Looking
at crises as vertical rather
At the other extreme,
the text
and to the strong
20
with no credibility
for countries
credibility
anchor
than horizontal
it
offers,
some speculate
problems and a precedent of good central banking, floating
is
probably the best choice, as
long as fear of floating does not become the perceived rule. Quite the opposite, a credible
commitment
to a countercyclical monetary policy during crises,
countries that
lie
in
between are those with good central banking, but which -
perhaps for historical reasons - are
taining inflation.
fear floating
a good substitute for
and ex-ante measures.
costly capital controls
The
is
Whether
still
in a currency
and hence de facto
give
concerned with estabhshing a reputation
board or not, the evidence
up ex-post monetary
discretion.
is
for
con-
that these countries
Our
analysis suggests
that these countries ought to look toward ex-ante measures to balance out the incentive-
based need
for active
monetary policy that
will
not take place. Indeed, for those countries
with very limited financial development, which require overly-active monetary policy in
order to restore adequate incentives, this advice
is
particularly pertinent.
They may be
best served by adopting a currency board and focusing efforts on improving international
liquidity
management
in the private
and public
sectors.
that the advantages include a lower interest rates and inflation risk premia due to the
enhanced credibility
in
controlhng inflation, and the potential positive impact that the latter
On
the cost side, there
is
the loss of seignorage.
21
may have on
financial deepening.
References
[1]
Aghion, Philippe, Philippe Bacchetta, and Abhijit Banerjee, "Currency Crises and
Monetary Policy with Credit Constraints, mimeo Harvard 2000.
[2]
Aizenman,
rowing,"
[3]
J.,
"Country Risk, Incomplete Information and Taxes on International Bor-
Economic Journal
Barro, R.,
99,
and D. Gordon, "A
March
1989, pp. 147-161.
Theory
Positive
of
Monetary PoHcy
in a
Natural Rate
Model," Journal of Political Economy 91, 1983, pp. 589-610.
[4]
Bemanke,
B.,
M.
Gertler,
tive Business Cycle
and
S. Gilchrist,
"The Financial Accelerator
in
a Quantita-
Framework," Handbook of Macroeconomics, Taylor and Woodford,
eds., 1999.
[5]
Caballero,
RJ. and A. Krishnamurthy,
straints in a
Model
of
"International
Emerging Market
and Domestic
Collateral
Crises," forthcoming in Journal of
Con-
Monetary
Economics, 2001a.
[6]
Caballero, R.J. and A. Krishnamurthy, "Smoothing Sudden Stops,"
mimeo MIT, May
2001b.
[7]
Caballero, R.J. and A. Krishnamurthy, "International Liquidity
ization
[8]
Pohcy
Caballero,
in Ilhquid Financial Markets,"
RJ. and A. Krishnamurthy,
Calvo, G.A., and
CM.
NBER WP #
Reinhaxt, "Fear of Floating"
Steril-
7740, June 2000a.
"Dollarization of Liabilities:
and Domestic Financial Underdevlopment,"
[9]
NBER WP #
Management:
Underinsurance
7792, July 2000b.
mimeo
University of Maryland,
2000.
[10]
Cespedes, L.F., R. Chang, and A. Velasco, "Balance Sheets and Exchange Rate Pohcy,"
NBER
[11]
Working Paper No. W7840, August 2000.
Christiano, L.J., C. Gust, and J. Roldos, "Monetary Policy in a Financial Crisis,'
preliminary mimeo. Northwestern,
[12]
Diamond,
November 2000.
D.W. and RG. Rajan,
"Liquidity
Shortages
and Financial Crises,"
U.Chicago mimeo, June 2001.
[13]
Dooley, M., "Responses to Volatile Capital Flows: Controls, Asset-Liability Manage-
ment and Architecture," World Bank Conference on Capital Flows, Financial
and
Policies, April 1999.
22
Crises
[14]
[15]
Gertler, M., S. Gilchrist
and F.M.Natalucci, "External Constraints on Monetary Policy
and the Financial Accelerator,"
NYU
Harberger,
Debtor-Country Managers and Pohcymakers,"
A.,
"Lessons
J.Cuddington and G.Smith
for
(eds.),
working paper, Feb 2001.
in
International Debt and the Developing Countries.
Washington: World Bank, 1985.
[16]
Hausmann, Ricardo, Ugo Panizza and Ernesto
Stein,
"Why
do countries
float the
way
they float?" Journal of Development Economics forthcoming (2001)
[17]
Kydland,
F.,
and
E. Prescott,
Optimal Plans," Journal of
[18]
[19]
"Rules rather than Discretion:
Political
Economy
The
Inconsistency of
85, 1977, pp. 473-90.
Lorenzoni, G., "Excess Interest Rate Volatility in an Intennediated System of Liquidity
Provision,"
mimeo MIT, November
Rogoff, K.,
"A Reputational Constraint on Monetary Policy," Carnegie Rochester Con-
2000.
ference Series on Public Policy 24, 1987, pp. 199-217.
23
A
Appendix
A.l
Detailed programs, definitions and assumptions
There axe three main assumptions we have made
Assumption
in the model:
(Non-observability of Production Shock)
1
The production shock
The
at date 1 is idiosyncratic.
identity of firms receiving the shock is private
information.
Assumption
A domestic
(Domestic Borrowing Constraint)
2
lender can only be sure that a firm will produce \ak units of goods at date
production based on physical reinvestment at date
Assumption
2.
Any
excess
neither observable nor verifiable.
1 is
3 (Liquidity Bias)
Foreigners lend
to
domestic firms only against the backing of w. Domestics lend against both
w
and Xak.
<
debt constraint with respect to foreigners of do,/
This gives a date
takes on additional debt with foreigners, the date
do.f
1
debt constraint
+ dif <
w. At date
1, if
a firm
is:
w.
Since domestics lend against Xak the debt constraint for domestic lending at date
1
is,
-^Jl+il)<w + -^{l+il)-d,j-doj
The program
for
a distressed firm
(PI)
V^
s.t.
=
at
date
maxe,di,/,di,d
the firm at date
for
di^d
and (n) are balance sheet constraints (net marketable
while constraint (Hi) reflects that
firm.
doj - dij -
1 in
new investment must be
1
how much
has only one decision:
Suppose that the firm accepts claims at date
making a date
1
fully
assets greater
contribution of
(P2)
V,
s.t.
f^
=
which
maxx,
J
is
1
than
is
finance will
purely technological.
it
extend to the distressed
of Xi y (face value of date 2 goods) in return
financed with new external debt df
w + Ak + Xi^j ~
doj + d\ f < w
24
liabilities),
paid with the resources received by
taking on debts of dj,/ and dij. Constraint {iv)
intact firm at date
i;)
9<1.
[iv)
An
w + A{e)k -
^,{i+ii} + d,,, + doj<w + f^{i +
9k =
^^+j^^
{Hi)
(i)
is:
dij+doj<w
[i)
(")
Constraints
1
do,/
— d\j
,.
Then,
Date
At date
problem.
distressed or intact.
0,
a firm looking forward to date
the decision at date
Thus
(P3)
iVs+Vi)/2
maxk.doj
do,/
<w
c{k)=
Market clearing
in the
itself as either
is,
s.t.
Egmlibrium.
can expect to find
1
(i+,5)(i+,j)-
domestic debt market at date
1
(capital letters denote
aggregate quantities) requires that the aggregate amount of domestic debt taken on by distressed
firms
is fully
funded by intact firms:
1
Therefore, market clearing,
Di,d
determines the domestic dollar-cost of capital,
An
equilibrium of this
respectively,
prices.
and prices
At these
Let us
economy
(11)
Xi^d,
if.
and date
consists of date
1
decisions,
(fc,
and
do,/)
(^,<ii,/,di,d,
Xid),
Decisions are solutions to the firms' problems (PI), (P2), and (P3) given
if.
prices, the
now study
=
market clearing condition (11) holds.
equilibrium in
more
detail.
investment choices of the distressed firm given
would choose to save as many of
its
(fc,
Starting from date
1,
consider financing and
A—1 >
ij,
then the distressed firm
do,/)- First,
production units as
if
can.
it
It
may borrow up
to
its
international
debt capacity,
di,/
K
the
amount
raised
=w-
(12)
do./.
from international investors,
"',
1' ^
,
,
restructuring, k, the firm will have to access the domestic debt
will choose to
do this as long as
A—
1
>
if
of capital. If the firm borrows fuUy up to
,
raise funds
right
hand
than the funds needed for
market to make up the
shortfall.
It
or the return on restructuring exceeds the domestic cost
its
domestic debt capacity,
dud
and
is less
=
it
will issue
debt
>'ak,
totalling,
(13)
with which to pay for imported goods of -^f^. As long as the sum of -^'^ and the
side of (12)
is
more than the borrowing need, the
25
firm
is
unconstrained in
its
reinvestment
at date
1
and
all
production units
domestic debt capacity (and perhaps
Intact firms can tender at
for purchasing domestic debt.
their excess international debt capacity of
They
will
>
A—
moment
that
is
is
w -
do,/ in
return
choose to do this as long as the return on domestic loans
i{.
1
>
and intact firms lend as much as they
which
its
than the international debt capacity).
less
most
exceeds the international rate, if
Assvune for a
In this case, the firm will borrow less than
be saved.
will
>
ij
ij
Then,
can.
A
directed to the distressed firms.
so that distressed firms
in total
borrow as much as they can,
the economy can import
~
"j '
goods,
necessary condition for all production units to be saved
that,
h^lILzA^^
We
(14)
shall refer to this constraint as the international liquidity constraint.
(14) binds,
all
production units are saved. Since there
relative to domestic
demand
for fimds, there
is
When
neither (13) nor
excess supply of funds from intact firms
no international liquidity premium, and
is
if
is
equal
to the international interest rate.
The
other extreme case
market requires
when both
is
and
(13)
(14) bind.
Equilibrium in the domestic debt
that,
Xak
1
~
+
if
w — dpj
1 + i^
Since (13) binds, distressed firms borrow fully up to their debt capacity.
purchase this debt with
all
of their excess funds. Solving for
_^afc
w-
That
market
is,
in this case if is
^^^
if,
As
(14) binds, intact firms
yields
^_^^
(15)
do J
above the international interest rate in order to clear the domestic
for scarce international liquidity.
transferable domestic resources
owned by
One
half times the numerator in (15) corresponds to the
distressed firms.
Define the index of domestic illiqmdity as the difference between the marginal profit of saving a
distressed production unit
and the domestic
interest rate of if.
When
(14) binds, this
is,
5d= A-if-1,
Equilibrium at date
1
can place the economy in one of four regions, classified according to
view
which of the two (domestic and international) liquidity constraints are binding. The horizontal
not.
corresponds to the case where the domestic constraint binds, and the international one does
The
vertical view corresponds to the case
where the international constraint binds and the domestic
26
one may or
on
may
in the text.
not. sj
>
if
and only
At the aggregate
if
both constraints bind, and
the economy
level,
is
domestic liquidity
Technical Assumption
the scenario
we focused
with respect to other domestics since they are
in aggregation; real
are positive; and the domestic cost of capital of
is
liquidity constrained with respect to foreigners;
at the individual level, firms are liquidity constrained
selling all of their
this
investment
constrained; domestic spreads
is
above the international interest
Zj is
rate.
(Conditions for Crisis)
1
(13) and (14) bind in equilibrium as long as the following conditions are met. Define,
,2(l+Zo)A
and,
(l
To ensure that in equilibrium
1
\ak
+i1
'
+
This comes from noting that
A—
+
(1
.^
<
.w
I,
=
'
It is satisfied,
guaranteed
<
k,
i'^,
z5)(l
we
jJ
+ A)
need,
>
il)c{k)
+
w>
\ak + (1+
+
i\)c{k).
and using the equilibrium expression that
^ak
w-(l +
±i
a < —
il){l
(1
+ il)c{k)^
i*o){l
A—
1
+zt)
"-
high relative to
ij.
1.
Given
this
assumption, 6
if
2A
(A
•
and Welfare)
In the case that Sj
we show that "^l^ <
step consider the
h{k,X)
>
0, welfare is increasing
first
Then we show that
0.
welfare
m \,
is
decreasing in
order condition,
= {1+ i;){l +ii +
- A-a{l-X)
A)c'(fc)
1
+
-Xa =
0,
z?
where,
ii
Implicitly differentiating the
=
first
Xak
w-
c{k){l
+
il){l
order condition
^^^^
=
c"(fc)(l
+
il)
=^
dhjk.x)
dX
first
+
order condition.
dm._
the
1 is
and k
is
X.
Proof: First
>From
<
-
decreasing in
first
+
io){l
k
>
if
for example, by choosing
Proposition:
at the
>
1
+
we can
z-)(l
+
dk
sign,
if
+ A) +
(^(1
27
+
A
il)c'{k)
^
;Aa
{\+iif
—r
\ dii
) dk
>
it.
To
arrive
and,
A
dh{k,X)
Thus we conclude that
'
J^
<
(.
^
__A_s
..^,^,^
M
+ il
r.
0.
Consider welfare next. This can be written as,
Now
substituting in the market clearing condition for
^=
By comparing
the
first
ward to show that
{jf~l
- ^W(l +
simplifies this to,
zf
A + h{A + a).
^S))
order condition for k in this expression to the previous one,
this function
is
decreasing
in
>
as long as s^
fc
Thus we can
0.
it
is
straightfor-
also conclude that
increasing in A in the vertical region.
welfare
is
A. 2
Monetziry policy and domestic collateral
In this appendix
we sketch a model connecting monetary
provide one explicit justification
The mechanism we
The
to borrowers.
constrained, firms.
for linking
policy to domestic collateral, and thereby
A to monetary policy, as we did in the main
text.
on debt-deflation and the resulting transfer from lenders
illustrate is based
lenders will be large, less constrained firms, while the borrowers will be small,
We do not
introduce banks into the model, although in practice these institutions
are surely affected by debt-deflation. In thismodel, a monetary system that tightens during crises has
the interpretation of corresponding to an environment where there
The
latter
We
too
little
domestic insurance.
equivalent to a decline in A in the text.
is
begin with the observation that tight monetary policy affects small firms more severely than
large firms.
before)
is
.
Date
There
is
a measure
5
of small firms,
investment of both types builds
of domestic collateral.
However small firms
afc'
differ
and a unit measure of
(for
i
=
s,l
-
small and large, respectively) units
from large ones
international collateral so that they are reliant on large firms for
simplify matters,
we
shall
assume that
all
in
all
two ways.
is
a reason
for
First,
they have no
investment needs. Second, to
small firms are distressed at date
large firms ensures that in equilibrium there
large ones (exactly as
1
(this
asymmetry with
small firms to be (partially) insured
against aggregate shocks by large firms).
As
firms,
before, large firms
borrow directly from the rest of the world to setup
on the other hand, finance
their date
their plants.
plants by borrowing from large firms,
borrow from international markets.
28
who
Small
in turn
We
is
introduce a role for monetary policy by assuming that
done in non-contingent (on aggregate conditions) pesos and
is
face value of one period domestic debt that each small firm takes
external shock to the foreign interest rate of ii(w), where
monetary
in conjunction with
policy, results in a
oj
€ {L,
domestic borrowing
all
date
at
H}
is
0.
at
Denote
one period.^"
At date
1
date
b as the
there
is
an
the state of the world. This,
nominal exchange rate of
ei{uj) that satisfies
the
domestic interest parity condition,
+
i^i{uj)
Thus
at date
1
ei{uj)
-
=
1
ifiuj).
the net worth of a small firm in terms of domestic collateral
ak^
—
b/ei(u})
Since large firms are at the other side of this transaction, and there
the domestic collateral of large firms at date
ak'-
Monetary
if
either there
for
is
the choice of
is
ei(uj)
no aggregate uncertainty,
monetary policy
in this setup.
in a debt-deflation channel for
date
+Sb/ei{uj).
1,
The
or
rigidity
if
is
w—
do,/-
Sk^+^k'<
1,
L
the debt
We
is
contingent on
state,
there
is
no
role
transfers resources
from large firms (domestic
is
Sk^
il is
+-^k'-.
The
international
low enough so that these
is,
shall
Xa>l +
and
^~J°j^y
on the other hand, we
ei,
one on the debt repayment, resulting
assrune that in the 7f-state,
assume the economy
iliH).
is
in the "crisis" equilibrium:
with,22
much
of the debt-deflation
rather than relying on
^"^°-f
l
monetary policy
economics, we do not address the issue of
issue
course,
borrowers)."'
ggy + Vfc'2
^"As in
Of
in the latter expression.
fully
is
we introduce
monetary policy that
investment needs are met by each firm. That
hi the
debt
the total investment need of both small and large firms
liquidity of the country
9\e' <
firm's
given the domestic interest parity condition. Note that
lenders) to small firms (domestic date
At date
a unit measure of large firms,
a private decision of the small and large firms respectively.
pwlicy
is
is
1 is,
To save notation, we have substituted the small
domestic debt
is,
why
+
i*i{L)'
literature, as well as in
much
of
monetary
the private sector does not write contingent contracts
—or suffering from — the central bank.
We
are currently
working on this
and conjecture that adding an extra layer of segmentation, now among domestics,
will allow
us to address this deficiency more adequately.
^'See, e.g., Lorenzoni (2000) for a
5 =
small S
model of debt deflation
in the context of an interbank market.
corresponds to the model we analyzed in the main text.
so that parameters lead to the situation
we
29
analyze.
It is
always possible to choose a
Since both large and small firms
(3) gives us
market clearing
of their domestic collateral in the market, the analogue of
sell all
of,
S{ak^-b/e,(L)) + ^(ak' + Sb/e,(L))
.,
.
j{w -do,/)
25a^lt£^^:^^Z£iI^(i+..(^))_i
',y-,,
-
=
From the
L
What
policy
we can
This dependence
state.
during
expression
last
has happened?
loose, ei(L) falls,
firms. ^'' Since
is
amount of depreciation
increasing in the
if rises
As monetary policy
is
the
tightens
(i.e.,
ei(L)
is
not allowed to depreciate)
In contrast,
toward the marginal product of
rate
is
A
—
firms, in
1.
a domestic insurance mechanism. Since date
based on the expectations of exchange rate
in
both
H
borrowing from
and L
optimal
states,
policy will call for a strong exchange rate in the i/-state, while a depreciated one in the L-state.
policy
is
not sufficiently expansionary in the L-state versus the //-state, there
insurance.
0,
it
The
latter depresses the eflFective
The
many
Gertler
of the
limited domestic
and hence,
et
al
(2001), or
is
Chang
date
(money)
is
et
al.
rate.
We
draw
this association
see this, consider adding
1,
the price of
for
fairly
standard -
is
it
either
that in our
money
because the price of the nominal
money. Since domestics only hold
is
linked to the price of domestic
an infinitesimal amoimt of an agent that demands money,
lends against domestic collateral, and has international collateral of
solves at date
is
However, the one deviation
(2000)).
determined by domestics and their demand
domestic collateral and money at date
To
mechanism through which the central
For the most part the connection
limited collateral in the vertical region does affect if and in turn the
exchange rate/domestic interest
collateral.
at
illiquidity.
papers exploring the accelerator mechanism are not explicit about
model, the fact that there
asset
explicit about the
affects interest rates/exchange rates.
indeed
(e.g.
for international collateral
If
interest parity condition
Throughout the paper we have not been
bank
demand
is
reduces the incentive to precaution against shortages in aggregate international
A. 3
if
and resources are transferred from large intact firms to small distressed
model the exchange
small to large firms
in
equivalent to our A function in the main text.
on net these resources loosen the financial constraint on investing
equilibrium,
hi this
clearly see that if
the amount of effective insurance from large to small firms declines.
crises,
is
is
(16)
V-
.
w
(say a bank).
This agent
1,
maix{v{in/ei)
+ m/eo +
xif
s.t.
x
+ m/ei<w}.
^'Resources are also transferred away from large distressed firms, but since these firms have the
same marginal product
as the small firms at date
1,
30
this is
a zero-sum transfer.
Where
v{-) is
demand
for real
money
balances. Normalizing 62
v'{m/ei)
Monetary policy
?i
=
v'{m/ei)
—
is
1
+
ei
=
=
1, this
gives the F.O.C.,
if.
the choice over m, which from this expression results in a vmique
gives the parity condition
we have used throughout the
31
text.
ei.
Setting
-,Ri'.^
ni6
Date Due
Lib-26-67
MIT LIBRARIES
3 9080 02246 0882