Financial Heterogeneity and Monetary Union
S. Gilchrist1
R. Schoenle2
J. Sim3
Boston University1
Brandeis University2
Federal Reserve Board3
Cambridge University
April 19th, 2016
E. Zakrajšek3
Disclaimer
The views expressed should not be interpreted as reflecting the views
of the Federal Reserve System or its staff.
Eurozone Crisis (2009–?)
Classic balance-of-payment crisis:
I
The mix of overvalued RERs and cheap credit fueled by economic
optimism led to over- and mal-investment.
I
After the Global Financial Crisis came a sudden stop.
Resolution of the crisis:
I
Realignment of overvalued RERs.
I
The mix of deflation in the “south” and reflation in the “north.”
I
Surprisingly hard to achieve—why?
Lessons from the Financial Crisis in the U.S.
Gilchrist, Raphael, Sim & Zakrajšek [2015]
Empirics:
I
I
Firms with strong balance sheets slashed prices.
Firms with weak balance sheets raised prices.
Theory:
I
I
Develops a GE model that can replicate such patterns.
Emphasizes the interaction between financial market frictions and
firms’ pricing decisions in customer markets.
•
What accounts for the resilience of inflation in the face of significant and long-lasting economic slack?
•
In particular, the absence of more substantial deflationary pressures during the "Great Recession" is
difficult to square with the Phillips curve common to most macroeconomic models.
Producer Price Inflation
Cyclical Dynamics of Producer Prices and Industrial Production
Core producer prices*
Industrial production*
Percentage points
Percentage points
5
5
0
0
-5
-5
-10
Peak: Jan1980
Peak: Jul1981
Peak: Jul1990
Peak: Mar2001
Peak: Dec2007
-10
Peak: Jan1980
Peak: Jul1981
Peak: Jul1990
Peak: Mar2001
Peak: Dec2007
-15
-20
-15
-20
-25
-25
-30
-24
-16
-8
0
8
16
Months to and from business cycle peaks
* Deviations from a linear trend estimated over the 24 months
preceding the specified recession.
24
-30
-24
-16
-8
0
8
16
24
Months to and from business cycle peaks
* Deviations from a linear trend estimated over the 24 months
preceding the specified recession.
Our answer
•
Economic forces that dampen the response of inflation to adverse demand or financial shocks reflect
the interaction between customer markets and financial frictions:
Relative Inflation
Financially unconstrained vs constrained firms
Percent
4
3-month moving average
2
0
-2
Low liquidity firms
High liquidity firms
-4
-6
2005
2006
2007
2008
2009
2010
2011
2012
Note: Weighted average monthly inflation relative to industry (2-digit NAICS) inflation.
Inflation Response to Liquidity
Coefficient
0.04
Estimate
+/- 2 S.E.
0.02
0.00
-0.02
-0.04
-0.06
-0.08
2006
2007
2008
2009
2010
2011
2012
IQUIDITY AND
F IRMS ’ P RICING B EHAVIOR IN 2008
antile regression estimates
Quantile
Response to Liquidity During Crisis
0.2
0.0
-0.2
-0.4
-0.6
Estimate
95% confidence interval
-0.8
OLS estimate
-1.0
0.10
0.20
0.30
0.40
0.50
Quantile
0.60
0.70
0.80
0.90
-
•
Indicator of current financial conditions - excess bond premium (EBP)
Inflation Response to EBP
Coefficients on EBP and commodity price inflation vary across 4-digit industry groups.
-
Is variation in industry-specific EBP coefficients related to the likelihood of financial co
across industries?
-
Use industry-specific size-age index to identify the likelihood of financial constraints
12-month PPI inflation and financial conditions
By industry-specific indicator of financial constraints
Coefficient on EBP (4-digit NAICS)
4
2
0
-2
-4
p < .10
p >= .10
^β = 1.11
|t| = 4.88
R-sq = 0.29
-6
-8
-10
-3.5
-3.0
-2.5
-2.0
-1.5
-1.0
-0.5
0.0
Median Size-Age Index (4-digit NAICS)
Note: Smaller values of the size-age index indicate a smaller likelihood of financial constraints.
12-month PPI inflation and commodity prices
By industry-specific indicator of financial constraints
S)
0.10
0.5
Output Response to EBP
Figure 7: Sensitivity of Industry-Level Output to Financial Conditions, 1973–2013
(By Industry-Specific Indicator of Financial Constraints)
8
p < .10
p >= .10
^ = -1.88
β
|t| = -3.77
R-sq = 0.22
6
Coefficient on EBP
4
2
0
-2
-4
-6
-8
-10
-12
-3.5
-3.0
-2.5
-2.0
-1.5
-1.0
-0.5
0.0
0.5
Median Size-Age Index
Note: No. of (4-digit NAICS) industries = 52. The figure shows the relationship between the
median SA-index of financing constraints at the 4-digit NAICS level during the 1973–2013 period
and the corresponding industry-specific estimates of the coefficient on the EBP; the dependent
variable is ∆12 log IPi,t+12 , the log-difference of IP in (5- or 6-digit NAICS) industry i from t to
t + 12 (see the text and notes to Table 3 for details). Observations plotted as diamonds () indicate
Inflation and Output Dynamics in the Eurozone
1992-2008
Avg. inflation (%)
Avg. output gap (%)
2009-2014
Core
GIIPS
Core
GIIPS
1.58
0.32
3.34
0.81
1.22
-1.38
0.66
-4.88
Panel-version of the NK Phillips curve:
πit = 0.449 Et πi,t +1 + 0.533 πi,t −1 + 0.104 (yit − ȳit ) + η̂i + êit
(0.051)
I
I
(0.049)
(0.048)
AUT, DEU, BEL, FIN, FRA, NLD, GRC, IRL, ITA, ESP, PRT
Annual data: 1970–2014 (unbalanced panel, Obs. = 429)
Is lack of deflationary pressures related to financial strains?
Inflation and Output Dynamics in the Eurozone
1992-2008
Avg. inflation (%)
Avg. output gap (%)
2009-2014
Core
GIIPS
Core
GIIPS
1.58
0.32
3.34
0.81
1.22
-1.38
0.66
-4.88
Panel-version of the NK Phillips curve:
πit = 0.449 Et πi,t +1 + 0.533 πi,t −1 + 0.104 (yit − ȳit ) + η̂i + êit
(0.051)
I
I
(0.049)
(0.048)
AUT, DEU, BEL, FIN, FRA, NLD, GRC, IRL, ITA, ESP, PRT
Annual data: 1970–2014 (unbalanced panel, Obs. = 429)
Is lack of deflationary pressures related to financial strains?
Inflation Dynamics and Financial Strains
Sample Period: 2008-2014
3
GIIPS
Inflation Residuals at t+1 (pct.)
2
Core
1
0
-1
-2
0.5
1
5
10
20
Sovereign (5-year) CDS Spreads at t (pps., log scale)
Heterogeneity as Propagation Mechanism
In this paper, we extend the theoretical framework to two-country
GE.
Study the consequences of forming a currency union among
countries with heterogeneous financial conditions.
Price War
During periphery’s liquidity crisis, core has a strong incentive to
slash markup to gain market share both home and abroad.
In contrast, periphery is forced to raise prices to secure cashflow,
cannibolizing its own future market share.
Self-Reinforcing Crisis
Possibility of RERs to appreciate for periphery rather than for core, a
feedback loop that reinforces the liquidity crisis of periphery.
Policy Options
Fiscal Union:
I
I
I
Trading state-contingent bonds among heterogeneous countries.
Highly beneficial to periphery but requires large transfers from core.
Are the costs of fiscal union bearable by core countries?
Fiscal Devaluation:
I
I
I
Certain mixes of fiscal instruments replicate the devaluation.
When can a unilateral fiscal devaluation be beneficial to core?
Depends on the strength of externality created by financial friction.
Preferences
Two countries: home (h = south) and foreign (f = north)
Continuum of households in each country: j ∈ Nc ≡ [0, 1]
(
j
home goods (h ) :
ci,h,t
, i ∈ Nh ≡ [1, 2]
Two types of goods:
j
foreign goods (f ) : ci,f
,t , i ∈ Nf ≡ [2, 3]
CRRA in habit-adjusted consumption basket xtj :
Et
∞
∑ βs U (xt +s , ht +s );
s =0
I
labor (h ) is immobile
j
j
j ∈ [0, 1]
Deep Habits
Ravn, Schmitt-Grohe & Uribe [2006]
Armington-Ravn-Schmitt-Grohe-Uribe aggregator:
"
xtj
=
∑
k =h,f
I
I
I
I
Z
ωk
Nk
1−1/η
j
θ
dk
ci,k,t
si,k,t
−1
1−1/e #1/(1−1/e)
1−1/η
η = elasticity of substitution within a type of goods
e = elasticity of substitution between types of goods
θ > 0 governs the strength of deep habits
0 < ωk < 1 governs the degree of home bias in consumption
Law of motion for deep habits:
si,k,t = ρsi,k,t −1 + (1 − ρ)
I
Z
Nc
j
dj;
ci,k,t
“Keeping up with the Joneses” at the good level.
k = h, f
Deep Habits
Ravn, Schmitt-Grohe & Uribe [2006]
Armington-Ravn-Schmitt-Grohe-Uribe aggregator:
"
xtj
=
∑
k =h,f
I
I
I
I
Z
ωk
Nk
1−1/η
j
θ
dk
ci,k,t
si,k,t
−1
1−1/e #1/(1−1/e)
1−1/η
η = elasticity of substitution within a type of goods
e = elasticity of substitution between types of goods
θ > 0 governs the strength of deep habits
0 < ωk < 1 governs the degree of home bias in consumption
Law of motion for deep habits:
si,k,t = ρsi,k,t −1 + (1 − ρ)
I
Z
Nc
j
dj;
ci,k,t
“Keeping up with the Joneses” at the good level.
k = h, f
Technology
Continuum of monopolistically competitive firms producing variety
of differentiated goods of type h and type f .
Production function (labor input, fixed operating costs):
α
At
∗
=
yit = ci,h,t + ci,h,t
hit
− φ; i ∈ Nh (0 < α ≤ 1)
ait
I
I
I
At = persistent aggregate technology shock
ait = i.i.d. idiosyncratic shock w/ log ait ∼ N (−0.5σ2 , σ2 )
φ = servicing cost of fixed coupon long-term debt
Heterogeneity in financial capacity: φ > φ∗ = 0
Frictions
Financial frictions: costly external equity financing
I
New shares sold at a discount because of asymmetric information
e1 claim raises only e(1 − ϕt ) of funds
I
“Lemons premium” ϕt ∼ AR(1) ⇒ financial shock
I
Makes expected shadow value of internal funds, Eat [ξ it ] > 1
Nominal rigidities: quadratic cost of adjusting nominal prices
Local currency pricing: law of one price does not apply
“Beggar Thy Neighbor” at the Micro Level
Deep habits make investment in market share profitable:
I
Investment takes the form of low markups, which exposes firms to
liquidity risk.
I
Optimal pricing strategy strikes the right balance.
Price war:
I
Liquidity crisis in the South is a good time for firms in the North to
steal market share by undercutting competitors’ prices in the south.
“Mr. Marchionne and other auto executives accuse Volkswagen
of exploiting the crisis to gain market share by offering
aggressive discounts. “It’s a bloodbath of pricing and it’s a
bloodbath on margins,” he said.”
– The New York Times, July 25, 2012
“Beggar Thy Neighbor” at the Micro Level
Deep habits make investment in market share profitable:
I
Investment takes the form of low markups, which exposes firms to
liquidity risk.
I
Optimal pricing strategy strikes the right balance.
Price war:
I
Liquidity crisis in the South is a good time for firms in the North to
steal market share by undercutting competitors’ prices in the south.
“Mr. Marchionne and other auto executives accuse Volkswagen
of exploiting the crisis to gain market share by offering
aggressive discounts. “It’s a bloodbath of pricing and it’s a
bloodbath on margins,” he said.”
– The New York Times, July 25, 2012
Optimal Pricing without Deep Habits
Assume flexible prices and no customer markets.
When α = 1, optimal pricing (home market) ⇒
Ea [ ξ a ]
× t a it it ×
Et [ξ it ]
η
η−1
| {z }
pi,h,t =
{z
economic markup
wt /ph,t
At
| {z }
real marginal cost
accounting markup
|
}
Financial frictions ⇒
Eat [ξ it ait ]
= 1 + Cov[ξ it ait ] ≥ 1
Eat [ξ it ]
Optimal Pricing with Deep Habits
Bring back customer markets (still flexible prices!)
Growth-adjusted, compounded discount rate:
sh,s +1 /sh,s − ρ
1−ρ
s −t sh,t +j /sh,t +j −1 − ρ
mt +j −1,t +j
×∏ ρ+χ
1−ρ
j =1
≡ ms,s +1
β̃ t,s
Optimal pricing ⇒
pi,h,t
=
η Eat [ξ it ait ] wt /ph,t
η − 1 Eat [ξ it ]
At
"
#
∞
ws /ph,s
Eas [ξ i,s ]
χ
−
Et
∑ β̃t,s Ea [ξ i,t ] ph,s − As
η−1
t
s =t +1
Optimal Pricing with Deep Habits
Bring back customer markets (still flexible prices!)
Growth-adjusted, compounded discount rate:
sh,s +1 /sh,s − ρ
1−ρ
s −t sh,t +j /sh,t +j −1 − ρ
mt +j −1,t +j
×∏ ρ+χ
1−ρ
j =1
≡ ms,s +1
β̃ t,s
Optimal pricing ⇒
pi,h,t
=
η Eat [ξ it ait ] wt /ph,t
η − 1 Eat [ξ it ]
At
"
#
∞
ws /ph,s
Eas [ξ i,s ]
χ
−
Et
∑ β̃t,s Ea [ξ i,t ] ph,s − As
η−1
t
s =t +1
Calibration
Key Model Parameters
Preferences & Technology
deep habit (θ )
persistence of deep habit (ρ)
elasticity of substitution b/w and w/in goods (η, e)
fixed operating costs (φ, φ∗ )
Nominal Rigidities
price adjustment cost (γp )
wage adjustment cost (γw )
Financial Frictions
equity dilution cost ( ϕ), Ea [ξ i ] = 1.12,
idiosyncratic volatility, a.r. (σ)
persistence financial shock (ρ ϕ )
Value
0.90
0.90
2.00, 1.50
0.08, 0.00
10.0
30.0
0.30
0.10
0.90
Implications of a Financial Shock in the South
In a monetary union (φ = 0.08, φ∗ = 0.00)
(a) GDP, pct
(b) consumption, pct
(c) hours, pct
(d) int rate , pp
2
1
0.5
0
0
2
1
0
−1
−0.5
−2
0
−2
−1
0
20
40
0
(e) RER(−), NER(−.), pct
3
20
40
(f) inflation, pp
20
40
0
(g) exports, pct
20
40
(h) CA, pct of GDP
1
0.5
1
1
−1
2
2
2
0
1
0
0
0
−1
0
−1
−0.5
−2
−2
0
20
40
−1
0
20
40
0
20
40
Red = Foreign (North) , Blue = Home (South)
NER (·−·) and RER (−) are Home/Foreign
−1
0
20
40
Implications of a Financial Shock in the South
Under floating exchange rates (φ = 0.08, φ∗ = 0.00)
(a) GDP, pct
(b) consumption, pct
(c) hours, pct
(d) int rate , pp
2
1
0.5
0
0
2
1
0
−1
−0.5
−2
0
−2
−1
0
20
40
0
(e) RER(−), NER(−.), pct
3
20
40
(f) inflation, pp
40
−1
0
(g) exports, pct
20
40
(h) CA, pct of GDP
2
1
1
1
1
0
0
0
−1
0
−1
−2
20
3
2
2
0
−1
−2
0
20
40
−1
0
20
40
−3
0
20
40
Red = Foreign (North) , Blue = Home (South)
NER (·−·) and RER (−) are Home/Foreign
0
20
40
Prices and Market Shares
Price War and Market Shares
Figure: Financial Shock, Relative Prices and Market Shares
(a) relative price
home markets, pct
(c) market share,
home markets, pct
2
(e) wage inflation, pp
2
0.5
1
1
0
0
−1
0
−2
0
20
40
−1
0
(b) relative price
foreign markets, pct
20
40
−0.5
0
(d) market share
foreign markets, pct
20
40
(f) markup, pct
6
0.5
1
4
0
0
2
−0.5
0
−1
−1
0
20
home, floating
40
0
foreign, floating
20
40
−2
home, union
0
20
foreign, union
40
Some Evidence: Market Share Dynamics During the Crisis
2010Q1=1.0
Figure 8: Euro-zone Market Share Dynamics
1.5
1.3
1.4
1.2
1.3
1.1
1.2
1.1
1.0
1.0
0.9
0.9
0.8
0.8
0.7
0.7
08
09
10
11
12
13
14
08
09
Portugal Export to Germany GDP
Germany Export to Portugal GDP
10
11
12
13
14
Italy Export to Germany GDP
Germany Export to Italy GDP
1.4
1.4
1.3
1.3
1.2
1.2
1.1
1.1
1.0
1.0
0.9
0.9
0.8
0.8
0.7
0.6
0.7
08
09
10
11
12
13
Greece Export to Germany GDP
Germany Export to Greece GDP
14
08
09
10
11
12
13
Spanish Export to German GDP
German Export to Spanish GDP
14
Heterogeneity As a Propagation Mechanism
In a monetary union
Alternative calibration: φ = φ∗ = 0.08
Financial shocks in both North and South.
(a) Home GDP, percent
(b) Home consumption, percent
0.5
0.4
0.2
0
0
−0.5
−0.2
−1
−0.4
−0.6
−1.5
−0.8
−2
0
10
20
30
40
−1
0
(c) Foreign GDP, percent
10
20
30
40
(d) Foreign consumption, percent
1.5
0.6
0.4
1
0.2
0.5
0
0
−0.2
−0.4
−0.5
−0.6
−1
0
10
20
30
40
−0.8
0
10
20
Alternative = (·−·) and Baseline = (−)
30
40
F INANCIAL H ETEROGENEITY AND M ONETARY U NION
Results
Monetary Union under Complete Risk Sharing
Monetary Union under Complete Risk Sharing
I
Dramatic reduction in consumption volatility
I
Requires large wealth transfers from the north to the south.
Figure: Financial Shock, Monetary Union and Complete Risk Sharing
(a) GDP, pct
1.5
(b) Consumption, pct
(c) RER, pct
0.5
0.5
(d) Contingent TR, pct
1.5
1
1
0
0.5
0
0.5
0
−0.5
−0.5
−0.5
−1
−1
−1.5
−2
0
−0.5
−1
−1
0
20
40
Home, baseline
0
20
40
Foreign, baseline
−1.5
0
20
40
Home, Complete
−1.5
0
20
40
Foreign, Complete
Gains vs Losses of Fiscal Union
Table: Costs and Benefits of Complete Risk Sharing
Welfare
Home country
Foreign country
Joint welfare
Con Equiv
MU (A)
Risk Sharing (B)
Percent
−274.86
−217.86
−492.82
−253.21
−236.96
−490.17
10.28
−9.13
−
Note: The consumption equivalent is the required minimum increase in
average consumption per period holding labor hours constant to make the
representative agent living in the economy under the floating exchange
rate regime no worse off by transitioning to the currency union.
Fiscal Devaluation
We consider a simple VAT-payroll subsidy swap rule:
VAT(τtV ) + payroll subsidy(ςPt )
FD rules that are linear in the resource gap of the home country:
yt
τtV = αFD × log
ȳ
Is there a parameter region that is mutually beneficial to both home
and foreign countries?
Fiscal Devaluation vs Flexible Exchange Rates
Optimal Rule vs Flexible Allocations
I
FD
= arg max
FD
fU(xt
t ; ht )
+ Et [V(st+1 )]g
Figure: Monetary Union w/ and w/o optimal FD vs Floating
(a) Monetary Union w/o FD
(b) Optimal FD
(c) Flexible
3
3
3
2
2
2
1
1
1
0
0
0
−1
−1
−1
−2
−2
−2
−3
−3
−3
−4
−4
−4
Home, y
Foreign, y
Home, c
Foreign, c
0
10
20
30
40
0
10
20
30
40
0
10
20
30
40
Welfare
Difference in welfare from the baseline w/o FD
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
ΔW
0.1
0
−15
ΔW*
−10
−5
αFD
0
Welfare for the Core
As financial frictions in the periphery change
(a) The effect of fixed cost
(a) The effect of issuance cost
2.5
1
φ=0.00
φ=0.05
φ=0.10
φ=0.15
2
ϕ=0.00
ϕ=0.10
ϕ=0.20
ϕ=0.30
0.8
0.6
1.5
ΔW*
ΔW*
0.4
0.2
1
0
0.5
−0.2
0
−10
−8
−6
−4
αFD
−2
0
−0.4
−10
−8
−6
−4
αFD
−2
0
Concluding Remarks
When firms engage in market share competitions, differences in
financial capacity across countries imply strong amplification
mechanism: “beggar-thy-neighbor” at the micro-level.
Monetary union impedes adjustment of RERs and exacerbates the
downturn in response to an adverse financial shock.
Unilateral fiscal devaluation by periphery may be welfare improving
for both periphery and core.