In this section, we will discuss the impacts of productivity and financial shocks on the economy. The numerical examination of dynamic analyses will focus on two parts. One is the quantitative importance of credit channel in a small open economy. The interest rate movements caused by international transactions will have an additional influence on the EFP movements. Furthermore, while current credit channel studies are examined in a closed economy, our study will investigate the implications of a small open economy on the financial sector. Since shocks alter the demand and supply for deposits
Variable c c A l n w K b * b
Steady State 1.2427 1.5217 0.3409 0.000 2.0427 11.159 32.482 0.7456 Variable R IB R B R L R T R D λ Ω EFP Steady State 0.01 0.01 0.01 0.01 0.01 0.3862 0.2713 0.000
Variable c c A l n w K b * b
Steady State 1.1108 1.4519 0.4058 0.0024 2.0624 13.643 1.3503 0.6665 Variable R IB R B R L R T R D λ Ω EFP Steady State 0.00497 0.0069 0.0067 0.01 0.00494 0.426 0.2127 0.0018
and loans in an economy, closely related to the consumption which is altered by the international trades, the exchange rate movements and trades drive the interest rate disparity across countries which further affects the transaction of international tradable bonds as well as the EFP.
The following calibrations are conducted under highly persistent shocks. We assume the AR(1) coefficients of shocks, ρl =ρk =ρn =ρm =0.99, while the persistence of
the prices, ρΠ* =ρΠm =0.8 and ρR =0.95.
Moreover, we assume that prices are rigid in the short run and that firms adopt the Calvo staggered pricing as the pricing strategy. To avoid further complication of the model, the price adjustment process is characterized as follows:
Π =t βEtΠ +t+1 κσt + (20) ut where κ >0 and
log log 1
t Pt Pt−
Π = − (21) which stands for the inflation rate of the aggregate price level. σt denotes the real marginal cost of goods production and can be identified as:
t t t
σ =ξ λ (22) κ is assumed to be 0.05 for calibrations.
5.1 Positive productivity shock: Atl =0.01
Figure 1 shows the impacts of positive productivity on the economy. Similar to the conventional wisdom, output rises which is accompanied by lower labor input resulting from the technological improvement. The expansion in the home production leads to lower export prices and exchange rate appreciations, which lowers the import price, causing greater imports. Therefore, the domestic consumption increases.
10 20 30
0x 10-3 Interbank rate
10 20 30
On the other hand, the domestic bond rate declines upon shock, but rises above the normal level with time, while the foreign bond rate drops below the steady-state level all the time and will turn negative in the end. The relative change of interest rates shrinks the spread between the home and foreign bond rates over time. This implies that the benefit from the liquidity service offered by the home bond declines gradually and thus drives greater demand for the foreign bonds, causing the home currency to depreciate over time. The home depreciation dampens the interest rate difference across countries, but fails to completely offset the disparity.
The lower benefit from the loan results in lower demand for loans and thereby drives down the loan rate. However, the central bank also reduces the interbank rate in reaction to the deflation due to the technological progress and causes the strongly procyclical EFP, in contrast to the countercyclical EFP in the conventional credit channel literature which excludes money and is conducted in a closed economy. This
10 20 30
0x 10-3 Interbank rate
10 20 30
result prevails no matter how persistent the growth rate of the high-powered money is.
This coincides with the “financial attenuator” of monetary policy in Goodfriend and McCallum (2007) which essentially demonstrates the importance of money in credit channel. It is because the expansionary money supply directly increases the demand for consumption, thereby deposits, which drives up the EFP.
5.2 A unit shock to the monitor of loans: 0.01Atn = −
In line with the current financial crisis, shocks to the credit market would be critical to the economy and the openness of the capital market has made the crisis spread all over the world rapidly. The widespread crisis has cast strong doubt on globalization. In addition to the examination of the financial crisis which originates from the inefficiency of monitoring for the loan making process, we also want to discuss whether
10 20 30
0x 10-3 Interbank rate
10 20 30
globalization helps reduce the spread of the financial shock. However, instead of investigating the transmission mechanism of the financial distress, we will focus on whether the financial shock to a small open economy can be dampened by the openness of the economy.
Figure 2 demonstrates the impacts of the shock to the monitoring for the loan on the economy. While the loan making lacks monitoring, it requires greater amount of collaterals for making the loans. Therefore, the demand for the home bond increases sharply, induced by the rising bond rate. The reduction of the liquidity services that the home bonds generate leads to greater demand for foreign bonds, accompanied by falling foreign bond rate. While the spread between the foreign and home bond rates turns negative, the home currency appreciates. On the other hand, international trades also cause the exchange rate movements.
The home appreciation, together with the financial distress, causes the home
production to drop while the consumption rises, benefiting from cheaper import prices.
Other interest rates, on the other hand, fall upon shocks. In particular, the central bank has to reduce the interbank rate to help the economy recover which has encountered declining output and deflation. The loan rate also drops due to the lower supply of loans.
The failure of monitoring triggers the asymmetric information problem in the model causes the EFP to rise, same as the EFP movement in the closed-economy framework in GM (2007) under the financial shock. The divergent movements of the bond rate and other interest rates place an emphasis on the importance of the distinction of interest rates in an economy with the financial sector. This effect is absent from the conventional credit channel literature.
The home currency appreciation seems peculiar for an economy experiencing financial crisis, but interestingly, it coincides with the movements of the US dollars since the subprime crisis broke out in 2007. Not only that the US dollars did not experience significant depreciations, but also there seems to be a great demand for the currency of the country where the crisis originated. The model here offers an explanation for the strong dollar: the demand for the US assets remain high to offset the loss in the collaterals for the loan making.a
Moreover, we have seen that the exchange rate movement has reinforced the impacts of the ineffectiveness of the loan monitoring on the economy. The home appreciation caused by the financial shock leads to higher export prices, thereby lowers the home production further. The calibration results of the model under lower degree of openness are shown in Figure 3. The comparison of Figure 2 and 3 demonstrates that the impacts of the financial shock on output increase with the openness.
a The small-open-economy setup here may not be consistent with the US economy. We assume that foreigners do not hold home bonds, and the currency of the small open economy is definitely not the international currency as the US dollars.
5. Conclusion
In this paper, we examine the credit channel in a small open economy by using a small-open-economy DSGE model with the banking sector. The discussions center on two aspects. One is the role of the credit channel in a small open economy and the other is the implications of economic openness for the banking sector. The steady state analyses show that the banking sector remains a significant role in the small open economy as in a closed economy. Moreover, the openness of trades drives down the interest rates, but raises the EFP. The analyses on dynamics, driven by the productivity and financial shocks, are consistent with the steady-state results, but additionally demonstrate that the exchange rate movements may reinforce the impacts of financial shocks on the economy.
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