Medium and long term implications of financial integration without financial development

June 29, 2017

By Flavia Corneli

We show that, in a two-country model where the two economies differ in their level of financial market development and initial capital endowment, financial integration has sizeable transitory as well as permanent effects. We confirm that, consistent with the Lucas paradox, financial integration in the medium term can reduce capital accumulation and increase savings in the financially less developed country, characterized by domestic capital market distortions, due to a higher risk premium in production activities. In the long run, however, integration produces higher levels of capital than in the autarky steady state. The opposite happens to the financially advanced economy, where integration initially boosts consumption and leads to a lower saving rate, and in the long run causes a reduction in capital compared with the autarky steady state. Two forces drive these results: precautionary saving and the propensity to move resources from risky capital to safe assets until the risk-adjusted return on capital equalizes the risk-free interest rate; assuming a constant relative risk aversion (CRRA) utility function, these forces are both decreasing in wealth.

The path to development is not uniform. This paper shows nicely the starting point matters, depending on the level of financial development and financial integration. This can also explain some of the shorter term difficulties that some economies suffered along their path.

Credit and Saving Constraints in General Equilibrium: Evidence from Survey Data

June 14, 2017

By Catalina Granda, Franz Hamann and Cesar E. Tamayo

In this paper, we build a heterogeneous agents-dynamic general equilibrium model wherein saving constraints interact with credit constraints. Saving constraints in the form of fixed costs to use the financial system lead households to seek informal saving instruments (cash) and result in lower aggregate saving. Credit constraints induce misallocation of capital across producers that in turn lowers output, productivity, and the return to formal financial instruments. We calibrate the model using survey data from a developing country where informal saving and credit constraints are pervasive. Our quantitative results suggest that completely removing saving and credit constraints can have large effects on saving rates, output, TFP, and welfare. Moreover, we note that a sizable fraction of these gains can be more easily attained by a mix of moderate reforms that lower both types of frictions than by a strong reform on either front.

Nice paper that shows how financial development can have some dramatic impact, and that relatively little reform can yield significant benefits.

Knightian uncertainty and credit cycles

June 13, 2017

By Eddie Gerba and Dawid Żochowski

The Great Recession has been characterised by the two stylized facts: the buildup of leverage in the household sector in the period preceding the recession and a protracted economic recovery that followed. We attempt to explain these two facts as an information friction, whereby agents are uncertain about a new state of the economy following a financial innovation. To this end, we extend Boz and Mendoza (2014) by explicitly modelling the credit markets and by modifying the learning to an adaptive set-up. In our model the build-up of leverage and the collateral price cycles takes longer than in a stylized DSGE model with financial frictions. The boom-bust cycles occur as rare events, with two systemic crises per century. Financial stability is achieved with an LTV-cap regulation which smooths the leverage cycles through quantity (higher equity participation requirement) and price (lower collateral value) effects, as well as by providing an anchor in the learning process of agents.

Interesting hypothesis that the prolonged recovery is due to economic agents tapping in the dark. One could say the same of policy makers, and of economic agents trying to read them, and vice-versa.

Should Unconventional Monetary Policies Become Conventional?

June 1, 2017

By Dominic Quint and Pau Rabanal

The large recession that followed the Global Financial Crisis of 2008-09 triggered unprecedented monetary policy easing around the world. Most central banks in advanced economies deployed new instruments to affect credit conditions and to provide liquidity at a large scale after shortterm policy rates reached their effective lower bound. In this paper, we study if this new set of tools, commonly labeled as unconventional monetary policies (UMP), should still be used when economic conditions and interest rates normalize. In particular, we study the optimality of asset purchase programs by using an estimated non-linear DSGE model with a banking sector and long-term private and public debt for the United States. We find that the benefits of using such UMP in normal times are substantial, equivalent to 1.45 percent of consumption. However, the benefits from using UMP are shock-dependent and mostly arise when the economy is hit by financial shocks. When more traditional business cycle shocks (such as supply and demand shocks) hit the economy, the benefits of using UMP are negligible or zero.

Few have tackled seriously the modeling of unconventional monetary policy. While one may argue about several of their modeling choices, Quint and Rabanal have the merit of taking a stand and setting the basis for analysis. And their results should provide fodder to possibly making unconventional policy conventional.