RULES ON MONETARY POLICY AND INTERNATIONAL IMPERFECT SUBSTITUTIONS OF ASSETS

Jurnal Ekonomi Manajemen & Bisnis - Vol. 19, No. 1, April 2018 JURNAL EKONOMI MANAJEMEN & BISNIS 77

Volume 19, Nomor 1, April 2018 P-ISSN: 1412–968X E-ISSN: 2598-9405

Hal. 77-88

RULES ON MONETARY POLICY AND INTERNATIONAL IMPERFECT SUBSTITUTIONS OF ASSETS

TAUFIQ CARNEGIE DAWOOD

Facultas Ekonomi dan Bisnis, Universitas Syiah Kuala, Banda Aceh

This paper revisits and extend discussions which evaluate the impact of different rules on monetary policy. Rules on one which excludes or includes stability of the exchange rate as an objective of monetary policy making, with currency mismatch

existence as given, on the fluctuations of major economic variables. In this paper I develop a financial accelerator model with financial intermediary consistent with cur- rency mismatch, and assume imperfect international substitutability of assets. This paper found that the variation of rule of monetary policy considered in the analysis produces variations in the fluctuations of the macroeconomic variable. However the impact of the different monetary policy rules on the stability of the macroeconomic variables is shock dependent.

Keywords: Shocks to Risk Premium Shocks, Economic Variations, DSGE, Policy Rules

78 TAUFIQ CARNEGIE DAWOOD

with the objective of targeting domestic inflation. It is noted that the above papers do not explic- An important goal for numerous countries in itly consider capital flows in their analysis. In par- the world is economic stability. Monetary policy ticular the aforementioned papers assumes perfect is one policy instrument to attain such goal. How- international substitutability of assets. Liu and ever conducting correct monetary policy is not Spiegel (2013) had found that by assuming im- always obvious. An issue that can effect the be- perfect substitutability of assets and capital con- havior and performance of policy making, in par- trols, monetary policy aimed at “smoothing” the ticular monetary policy making, in small econo- exchange rate is optimal. It should be noted that an mies which are open to international flows of trade important feature of business cycles and monetary and financial flows are the problem of currency policy responses in small open economies is that mismatch.

INTRODUCTION

they are highly influenced by international capital Many developing countries which opened up flows (Kaminsky and Reinhart, 1998). their capital accounts face the problem of curren-

I revisit and extend the above arguments. I cy mismatch. If their banks borrow from abroad develop a financial accelerator model consistent or from global financial markets, the borrowing with currency mismatch, and assume imperfect terms must be specified in currency of foreign international substitutability of assets. countries.Thus repayments of interest and princi-

To the author’s best account, this analysis is pal to the international lenders must be made in the first scholary work which uses models to ana- currency abroad.But these funds are lent out to lyze policy making with the existence of currency

domestic firms and individuals, and are repaid in mismatch and balace sheet effect. currency of the domestic economy. But markets

Then I explore the variations in oscilations for forward transactions for the currency of the do- of imporatnt variabels of the macroeconomy by

mestic economy may not exist.If it does, the level comparing policy rules that places large weights of trading in the market may be “shallow” and the the stability of the real rates of exchange and rules level of lliquidity is still low. Thus making hedg- on policy that place small encumbrances on the ing against risk of sudden changes of the rates of real rates of exchange rate robustness. exchange intricate and exorbitant. (Eichengreen

and Hausman, 1999, Calvo (2006)).

THE MODEL

There exists discussions of the effect of curren- cy mismatch on rules of monetary policy choices

This study develops an infinite horizon small that uses uses a Dynamic Stochastic General Equi- open economy model with financial intermedia- librium Model with Balance Sheet Effects/Finan- tion and a financial accelerator mechanism of Ber- cial Accelerator Model of Bernanke et.al. (1999). nanke.et.al (1999), and I assume that the home

But the conclusion of these discussions has not country in the international market for capital acts yet found its accord.

as a borrower in the net sense. One of the view proposed by Cespedes et.al.

The banks of the domestic economy provide (2004), made an argument in which a regime of credit to households by purchasing bonds which flexible rates of exchange, coupled with rules has single period duration which is denominated which targets inflationary changes offers higher in home country’s currency issued by households. level of robusteness to the macroeconomy to with- These banks finance their lending in excess of stand shocks from abroad, relative to rules which their net worth by borrowing from foreign inves- attempts on fixing the rates of exchange of the tors/creditors. economy. On the otherhand Choi and Cook (2004)

There are several assumption which I impose found that a rule which fixes the rates of exchange to the model. The first assumption is that there ex- fixed exchange rate rule that can make the banks’ ist currency mismatch for the home country. Cur- balance sheets stable, offer larger robustness than rency mismatch can be defined as follows. Sup- do a rule which uses the domestic interest rate pose that the ome country faces a world interst

Jurnal Ekonomi Manajemen & Bisnis - Vol. 19, No. 1, April 2018

rate, and due to the issue of “original sin” domes- With these assumption at hand, the optimization tic banks must borrow and redeem its foreign debt problem of the household can be written as fol- and interest, from issuing one period bonds, in the lows. currency of foreign countries (for example US$). The second assumption imposed in this study is that there does not exist markets for instruments to hedge against risk of changes in the foreign ex- Subject to the following budget constraint: change for the home country’s currency. The im- plication is that home country’s banks do not cover theirselves against foreign currency risk by going into contract such as using instruments of markets

Denote B t as the domestic one period bonds

of futures for foreign currency. Third, household and non-financial firms cannot borrow in the inter- denominated in domestic currency issued by

household and sold to banks at the end of period national capital market, fourth, Assume that there

is imperfect international substitutability between as real profit from

t, W t as the wage and ∆∆ dt , ft ,

ownership of firms, C t is the real consumption of domestic and foreign assets, fifth to ensure the

Z t , B t existence of a unique positive stochastic discount − 1 is the t-1 bonds redeemed by households from banks with paying the gross in-

final goods

factor, and because of the previous assumption, terest R t and R kt serving as capital rental/returns. assume that (generalized) Uncovered Interest Rate Parity holds and the international financial market The condition necessary for the typical house-

hold optimization problem is the following: is complete, sixth, banks can hold two types of

assets, domestic assets issued by households and

γ − aC 1 t γ t γ 1 γ γ − 1 C t + bm t t

foreign assets. Seventh, households owns and rent

labor and capital to firms. The first order condition for consumption and

holding real money balances is.

Households

Assume a typical household in the economy − 1   γ

γ − aC 1 t which selects a combination of leisure and con- t t + 1  1 γ  − P  1

C t γ + bm t γ t γ

sumption, and each combination of lesssierue gives a level of utility to the household. It is also The substitution intra-period among consump-

assumed that the producing firm is owned by the tion with work forthe household is as follows: typical households. Income of the typical house- t λ

P t L hold is generated from the supply of capital and t labor the production process, and from profits And the substitution across time between and

purchasing capital and consumption is as the fol- residual of the producer of intermediate output

lowing:

products and importer of intermediate goods firms. Moreover the typical household In addition, 2 

+− 1 δ + ψ  k

 += 1 β E t  λ t + 1   R kt 1 

2   k t + 1       amass debt.

 λ t  P t + 1 (6)

towards the end of each period t, the household

as the gross rate of return of domes- To model the typical household this study em-

Denote

ploys an amended form of Dib (2011) by adding tic risk free asset. The inter-temporal substitution two assumptions to the model. The first assump- from issuing domestic bonds is:

tion that households are accumulating debt with

  πλ t + 1 t  

the borrower pays the contemporaneous domes-

tic interest rate for its debt. This assumption is in Denote δ and q t being the rate of deprecia- line with the assumption that the economy is a net tion for capital and the real rate of exchange re-

debtor. The second assumption, households does

spectively.

not hold foreign bonds or borrow from abroad.

80 TAUFIQ CARNEGIE DAWOOD

Banking Sector

country’s currency issued by domestic households

The main economic agent in this model is the and foreign one period bonds. On the liability side bank sector. We define the setting for the bank- the bank has one type of liability; domestic one

ing sector as follows. Assume that this economy period bonds denominated in foreign currency is- is small relative to the rest of the world and it is sued by the bank and purchased by foreign inves- open to international trade and international flows tors/lenders. We assume that the domestic banks of capital. Assume further that, given the global holds both types of assets in their portfolio. By rates of interest, this economy is a debtor in the assuming imperfect substitutability between do- net sense. Assuming asymmetric information mestic and foreign assets, assume that there is a between domestic households with international portfolio adjustment cost from altering the com- investors/lenders such that domestic households position of the portfolio between foreign and do- do not have access to issuing bonds to foreign mestic assets. creditors but can issue and sell one period bonds

A banker starts at time t with net worth nw t . in domestic currency to domestic banks (domestic On the period t the banker purchase domestic bonds which has single period duration which is bonds which has single period duration which is denominated in home country’s currency). How- denominated in home country’s currency from l , h

ever the banks has access to a complete asset mar- households, b t which in return provide a rate ket which can be traded internationally.

of return which are free of risk denoted as R t in domestic currency. In addition banks also choose

Assume that there are one unit measure of to purchase one period foreign currency denomi- l , banks owners which are neutral towards risk, and f nated bonds b

which gives non-diversifiable free *

each are prone to risk which are idiosyncratic in return in foreign currency of R t

. Following Dib nature and are observed but only imperfectly. As- (2011) assume that R t is exogenous and follows sume that banks have access to foreign borrowing

a stationary process:

and a complete assets market which can be traded

t = ( 1 − ρ r * ) ln R + ρ r * ln R t − 1 + ε r* t

ln * R

internationally. And assume that the bank can then intermediate these funds to domestic households * Assume ρ

r * ∈− ( 1,1 ) . Denote R as the steady by purchasing domestic bonds which has single state foreign interest rate, σ r is the standard de-

period duration which is denominated in home viation of R t and is an i.i.d. ε r*t is a standard nor-

country’s currency issued by domestic house- mally distributed random variable.

holds. To finance this purchase in excess of net worth, In excess to its net worth, the bank borrows the banks issues and sells domestic one period from foreigners by issuing and selling domestic bonds denominated in foreign currency to foreign one period bonds denominated in foreign currency investors/lenders and convert the proceeds to be in to foreign investors/lenders. The banks then use the currency of the home country by using the spot

these funds to either lend in the domestic economy nominal rate of exchange e t . in domestic currency by purchasing domestic one

Denote e t as the domestic currency price of

period bonds denominated in domestic currency one unit of foreign currency. Assume that inter- or purchase foreign one period bonds. Assume est rate for the domestic one period bond denomi-

that foreign investors/lenders will only purchase * nated in foreign currency issued by the bank is R

domestic assets issued by domestic banks in the which must be paid in foreign currency. form of domestic one period bonds denominated

In addition assume that domestic assets are in foreign currency. Thus we have the setting of imperfect substitutes for foreign assets and there currency mismatch.

is a portfolio adjustment cost represented by the Because the domestic banks can also purchase parameter Ω b . As a note, by the assumption of foreign one period bonds, thus the bank has two imperfect substitutability between foreign and types of asset; domestic bonds which has single domestic assets, the domestic bank would hold period duration which is denominated in home both asset despite the portfolio adjustment cost.

Jurnal Ekonomi Manajemen & Bisnis - Vol. 19, No. 1, April 2018

Specify the debt of the bank, in the form of do- period bonds denominated in domestic currency), mestic one period bonds denominated in foreign R t , interest from purchasing foreign one period * d

currency issued by bank “h” and sold to foreign bonds R t which is exogenous and R t which is

investors, multiplied by adjustment cost in excess the interest rate that the bank must pay in foreign of net worth as:

currency when issuing and selling domestic one period bonds in denominated in foreign currency

to foreign investors. As in Bernanke et.al. (1999)   b lh , 

the interest rate R t is state contingent to eliminate

any aggregate risk to foreign investors.

t lf

The implied state contingent minimum effi-

ciency level ω at which default is avoided is: b lh Ψ , t = bt

2 ( Ψ t )   NW t   

R t b bt  = t d    t lh , + e t + 1 bt lf R ,  b t b   1 + Ω b −Ψ  −

 e 

The term Ψ t denotes the share of domestic Assuming a realized spot rate of exchange in

currency bonds to total portfolio held by the bank nominal terms e t , and for the non-default case, the while ψ denotes the steady state share of domestic expected payoff for the bank is the proceeds that it currency bonds in the portfolio. The term e t + 1 lf , b receives from the domestic one period bonds de- bt

is viewed as the domestic currency equiva- e t

nominated in domestic currency and foreign one

lent of the foreign bonds held by the bank in their period bonds minus the interest paid to foreign in- portfolio.

vestors/lenders from their holding of domestic one Following Choi and Cook (2004) for the do- period foreign currency denominated bonds which

mestic currency lending, denote the banks post is a multiple of the non-default probability multi- one period net revenues in nominal terms which plied by the probability of no default. also includes purchase of foreign assets as

In the case of default the bank receives noth-

ing. Thus the expected payoff to the banker can be ω t  t + e + t 1 b t +  1  R t e t R b t   evaluated in the currency  of the home country. De- written as:

lh , * lf ,

note l ω

t as bank l’s technology at time t, which

e t + 1 * lf ,  f

() ω t + 1  R t b t  +

lh ,

R t b bt   e  

are variables that random in nature, and for each

of the banks they are independent with probability distribution being lognormal with expected value

Following Choi and Cook (2004), the ratio of

of 1. Foreign investors/lenders can observe l ω

t + 1 the banker’s payoff expectation encompassing the

only with cost of monitoring which equals to the pertinent magnitude of the random variable ω ratio of the banks overall asset such that probabilities are positive can be written

f () ω = ∫ ω d ω − ω

d ω In this paper we assume that the optimization

behavior of foreign lenders is exogenous to the

The payoff expectations of creditors Closely following Carlstrom and Fuerst in abroad (investors) are payments of in- (1997), the optimal financial contract can be de- terest received net of capital control tax

economy.

scribed as follows. The bank chooses the quantity for the example of non-default, or bank’s of domestic currency denominated lending (which value (net for the cost of liquidization) for is equivalent to the amount of domestic one period example of default and are denoted in the

bonds denominated in domestic currency) H b

and F following expression:

e t + 1 lf * ,  tion of the idiosyncratic risk ω t , interest rate for

foreign one period bonds b t prior to the realiza-

lh ,

 bt e t  

domestic currency lending (from purchasing one

82 TAUFIQ CARNEGIE DAWOOD

The fraction of expected payoff en- the necessary conditions can be viewed as compassing the pertinent magnitude of a generalized UIP condition. This is be-

the random variable ω such that prob- cause if the portfolio adjustment cost Ω b

abilities are positive can be written as: were zero under the assumption of perfect

g () ω = ω ∫ ω d ω +

) substitutability between foreign and do-

d ω mestic assets, then we get an open econo-

my version of the supply curve of invest-

This expression is the share of net as- ment finance a.la. Bernanke et.al (1999) set which goes to foreign investors.

where the existence of financial frictions

To construct the expression for the op- in the form of liability dollarization pro- timal financial contracting problem we duces a wedge in the standard UIP condi-

assume the following. tion in the form of a (gross) default risk

First assume that the bank has adequate premium (which in Bernanke et.al (1999) power for bargaining in order for gather- it is signified as being external financing ing residual returns. Second assume con- premium). And if the gross premium for

stant dollar price of foreign goods. Finally the risk of default κ t (which is a function

assume that the foreign investors/lender of the credit worthiness of the bank) is receives average returns in ex post fash- one (which implies net default risk pre- ion which sums to the risk free rates of mium is zero) then this expression would interest in foreign currency which assume * reduce to a standard UIP condition. to be exogenous R t .

As argued in Choi and Cook (2004) as-

The optimal financial contracting sume that the bank productivity ω is in- problem can be written as follows:

dependent of any individual characteristic

of the bank. With this assumption define

 ω Max lh , lf ,  E () ω t 

the aggregate constraint of all banks in the economy as:

 e t 

t + 1 )  g () ω t + 1       R t b t

The necessary condition of the bank- 

er’s optimizing problem is 

g () ω t   1     RB t t H − 1 + e t + 1 * F   

   e t + 1   R t κ       In addition the first order conditions in

aggregate form can also be written as: ΩΨ b ( t )  

Denote κ t

f l () as the gross

ω t + 1 + λ t g () ω t + 1 

H default F risk premi-  

−Ψ  * − e t + *  ( Ψ t −Ψ ) t + *  t + t  ΩΨ  b ( t ) t 1 R R t  − e 1 R t  B B    

um of banks which following Choi and 2

Cook (2004) depends on the credit wor-

thiness (and implying it depends also on t Define the real exchange rate as

t = s eP

P the leverage ratio) of the bank. t . For convenience redefine the ag-

gregate first order condition and the pro-

lh ,

lf ,

() t + 1 + λ t + 1 g ' () t + 1   R t b t + e t t b bt  = 0

portion of the banks’ portfolio held in do- mestic assets to be in real terms as follows.

The first of the above expressions for

Jurnal Ekonomi Manajemen & Bisnis - Vol. 19, No. 1, April 2018

By assuming f’( ) > 0, this is interpreted as that

an increase in the interest rate differential would increase the foreign demand for domestic one pe-

f () ω t + 1 + λ t + 1 g () ω t + 1

riod bond denominated in foreign currency issued

by the banks. In the view of the foreign investors,

P t ψ t imperfect substitutes for foreign bonds with simi-

this implies that domestic one period bonds are

Following Carlstrom and Fuerst (1997) and lar maturity. Bernanke et.al. (1999), assume that bankers are

risk neutral with constant subjective discount fac- Discussion of net worth and default premium

Now we establish the relation between nomi- ry period and in the final period they will consume nal exchange rate, net worth and the default pre-

tor and that a fraction 1 − γ of bankers die in eve-

all of their net worth. Using this assumption and mium of the bank. This relationship is embedded redefine the debt of the bank in terms of the do- in equations (6), (8) and (12). Note from equation mestic currency using the redefinition in equation (8) that all variables except ω t and e t are prede- (12), we can aggregate the one period bonds is- termined. Suppose the nominal exchange rate de- sued and sold by domestic banks to foreign inves- preciates (which implies e t rises). According to

tors (which is also the supply of one period bonds equation (9) and the expression for g () ω t + 1 , this is

in foreign currency issued by domestic banks) as coupled by an increase in ω t . From equation (6) in the following difference equation:

and (8), a rise in ω t requires a fall in f () ω t + 1 and

thus by equation (12) the net worth of the bank s t + 1 π t + 1 H F  Ω b 2  s t + 1 π t + 1 K   H F d  t = * ( b t + sb t t )  1 + ψ − ψ  − Γ b t − 1 + sb t − 1 t − 1  + s t + 1 π t + 1 Γ * d t − 1 falls. For a given level of total do-

s t π t + 1  2 ( t )  s t * t t + 1 π R   π t t  s t * R t π  π t + 1 π t mestic debt this in turn implies that

the ratio of debt-to-net worth (lever- This is basically the amount of borrowing in age ratio) rises. Following Choi and Cook (2004), foreign exchange taken by the banks from the in- around the steady state, the default risk premium ternational capital market. Because the model as- κ t is an increasing function of the leverage ratio, sumes only banks borrow from abroad thus this thus κ t rises. In sum, a depreciation of the nomi-

is also equals to the total stock of the country’s nal exchange rate increases the default risk pre-

foreign debt.

mium for the bank.

Following Choi and Cook (2004), and denote With the establishment of the relationship be- the survival rate of the bankers to the next period tween net worth of the bank with the default risk as Γ , the net worth of the banks can be written as: premium through the change in the exchange rate,

NW F

H ()

t =Γ f 

we can define the financial accelerator model for

ω   RB t t − 1 s t − 1 R t B t − 1  

the banking sector. Following Bernanke et.al. Following Corsetti, Dedola and Leduc (2011), (1999) and modifying it, the financial accelerator the assumption of imperfect substitutability be- model for the banking sector can be defined by the tween domestic assets and foreign assets imply following equations. that the demand function for domestic one period

The first equation is the gross return of port- bonds denominated in foreign currency issued by k folio of the bank R which can be defined as fol-

banks (in terms of domestic currency) is upward lows.

F sloping with respect to interest rate differentials.

R t = E t   RB t t + H s t + 1 RB F t t   

( B t + s t B t ) Using a modified version of Liu and Spiegel

(2013), the demand for the one period bonds is- Denote s t as the real exchange rate. sued by banks is denoted with the following:

The relationship between risk premium and

net worth can be defined as:

E t  R * t + 1   = NW t + 1   

84 TAUFIQ CARNEGIE DAWOOD

Equations (13) and (15) may be viewed as rep- The final goods can be used for consumption resenting the supply curve for external financing and investment so that the resource constraint can from abroad. Firstly foreign lenders demand the

be written as:

bonds issued by the domestic banks depends on Z t = C t + I t the interest rate differentials. On top of this, fol-

lowing Bernanke et.al. (1999) the foreign lenders Profit maximization with respect to equation (investors) also require a default risk premium to (20) result in the following demand functions of lend to the bank (i.e. to purchase the bonds issued domestic and imported differentiated goods: by the banks’).

The third equation is the law of motion for the

Y dt ( 1 −

f ) dt

net worth of the banking sector.

ft In difference equation in can be written as:  Y dt = ( ω

The consumer price index is defined as:

=  1 − ω f 1 dt − ν + ω f 1 ft − ν − P ν  ( ) P P  1

The firm

 The model specification in this section follows

from Dib (2011). The firms are owned by house- The domestic intermediate goods producing holds. The production sector consists of three sec- firms and import intermediate goods firms

tors. The final goods firms, the domestic interme- Each domestic intermediate goods producing diate goods firms and the imported intermediate firms is monopolistically competitive and adjust goods firms.

price according to Calvo (1983) and a fraction of ( 1φ − ) firms can reset their price, while remaining

Domestic and imported composite goods

prices are unchanged. Each firm produce differ- The composite domestic and imported inter- entiated product by employing labor L t and capital mediate goods ( YY dt , fy ) are by combining a con- K t from households and using the following tech-

tinuum of differentiated domestic and imported nology:

, α ∈ () 0,1 sive intermediate good as ( P dt (j), P fy ( ), j PP dt , fy ) , profit maximization results into the following demand

( dt (j), fy () j )

AL t t ]

intermediate goods α Y Y . Denote the succes- 1 −

The exogenous technology shock A t evolves

functions for each goods “j” of domestic and im- according to the following law of motion: ported differentiated goods, the Producer price in-

ln A t = ( 1 −

A ) ln A + ρ A ln A t − 1 + ε At

dex (PPI) and Importer Price Index (IPI).

The domestic intermediate goods can be used () j = dt  P dt () j Y  

 Y dt

domestically or exported so that

P dt

Y t () j = Y dt () j + Y xt () j

P dt =  ∫ P dt () j dj 

The foreign demand for domestic goods are () j =  P ft () j Y  ft 

defined as follows.

The aggregated foreign demand for domestic

The final goods firms

exports can be written as:

− The final goods firm is perfectly competitive. τ 

dt 

dt 

 s t t It aggregates domestic and imported intermediate 

Y xt =

goods ( YY dt , fy ) to produce final goods z t with fol- Foreign price P t evolves according to the fol-

lowing aggregation technology:

lowing law of motion:

+ ω ν f Y ft ν 

 ( 1 − ω f ) ν 1 Y dt ν 1 1 1 

Jurnal Ekonomi Manajemen & Bisnis - Vol. 19, No. 1, April 2018

The Steady states are denoted as variables

1 − ρ    π  () π ρ π   P t − 2   ε π without the time subscripts. The shock to mon-

Firms chooses price P dt () j to maximize profit etary policy shock obeys a lae of motion which is subject to equations (17) and (27). Profit maximi- denoted as follows. zation yield the following aggregated first order

ln v t = ρ v ln v t − 1 + ε vt ; ρ v ∈ () 0,1

condition:

() j

Current account

P L t () j qP The current account for this model implies

t ° dt

R kt = Y t () j

that the flow of foreign bonds, adjusted for default

P t K t () j qP t dt risk premium of the bank is equal to the difference

E t l ∑ = 0 ( βφ λ ) t + 1 yq t + 1 t + 1 between the export and import of intermediate

P dt

() j = θ

l ∑ = 0 ( βφ λ ) t + 1 y t + 1 goods of the small open economy with the other P dt + 1 countries in the world. The current account can be

written as follows.

° = P Define dt P dt and denote q t is the Lagran-

− B t − = p * 1 dt y xt − gian multiplier applied to the production function

ft

constraint in the profit maximization. Define the aggregate domestic price index as:

Conditions of Equilibrium

P dt = φ P dt − 1 + ( 1 − φ ) P dt

With the assumption that all economic agents

which are the firms, impoters plus domestic pro-

Imported Intermediate Goods

ducers and consumers are symetrical, the require- Homogenous intermediate goods are imported ment conditions for equilibrium are the following.

by a continuum of j ∈ [] 0,1 importers which are of

t = M t − 1 + T t , b t = 0 b t = 0 , y dt = y dt ( ), j y t = y t () j ,

the Calvo (1983) type. A fraction of ( 1φ − ) firms

y xt = y xt ( ), j y ft = y ft ( ), j P dt = P dt ( ), j P xt = P xt () j

, P ft = P ft () j for all t ≥ 0 .

can reset their price, while remaining prices are

unchanged. Firms chooses price P ft () j to maximize profit subject to equation (19). Profit maximiza-

ANALYSIS

tion results in the following first order condition.

Calibration

E t ∑ l = 0 ( βφ λ ) t + l y ft + l () j P * t + l

In this study, the paremeters for the model for

P ft () j = − θ P ft 1 + θ ∞ l l

E t ∑ l = 0 ( βφ λ ) t + l y ft + l () j

firms and typical households are calibrated form

Peters (2008) for Thailand. Two saperate rules for eP t Define the real exchange rate as t s t =

P ft + l

monetary policy are employed for the analysis at

Define the aggregate import price index as: hand. A rule with large encumbrances on the real

rates of exchange rate robustness () ρ s in the mon-

P ft = P ft − 1 + ( 1 − φ ) P ft

etary policy rule, and the other rule with small

The Central Bank

weight. The current analysis sets the magnitude Following Peters (2008) assumes that the of ρ s = 1.3202223 for the rule on monetary policy small open economy’s central bank oversees the which place lesser encumbrances on the real rates

performance of the rates of interest in short period of exchange rate robustness. And this analysis sets terms denoted R t , when there is deviancy of of na- the magnitude of ρ s = 4 for the rule on monetary tional output production Y t , inflation π t , money policy which place greater encumbrances on the supply growth µ t , plus the real exchange rate s t real rates of exchange rate robustness. The rule for monetary policy and could be denoted

For the banking sector, this paper employs the as follows:

following parameter values. The steady state val- ues for portfolio share of domestic bonds of the

 b   s  s  ln v Ψ follows from Liu and Spiegel (2013)

banks

while the parameter value for the survival rate of

86 TAUFIQ CARNEGIE DAWOOD

the banker Γ and the default risk parameter ζ fol- Technology shock

lows Bernanke et.al. (1999).The values of the pa- Next consider a positive shock to technology. rameters are presented in appendix C.

Following a positive shock to technology, con- sumption (c) and production of intermediate goods

Impulse response function (IRF)

(y) rise in the two cases.Inflation fell in both cases. In the current paper I analyze impulse response In contrast he real exchange rate and domestic in-

graphs of various variabels of the macroeconomy terest rate did not change very much on impact. which are respectively, output of intermediate

In contrast to monetary policy shocks there are goods (y), consumption(c), domestic nominal in- no significant differences in the fluctuation of the

terest rate (r), the real exchange rate (s) and CPI macroeconomic variables, (Figure 1 and Figure 2). inflation (pi). The shocks considered are monetary

policy shocks, technology shocks and foreign Shock to foreign inflation

price shock.The graphs of the impulse responses Finalay observe a positive shock to foreign are formed for the subsequent two rules of mon- inflation. With a positive foreign inflation shock,

etary policy considered in this analysis; case one CPI inflation consumption and domestic interest where greater encumbrances is placed on the real rate rose in both cases.In addition, the real ex- rates of exchange rate robustness, while case two change rate appreciated in bot monetary policy places lesser encumbrances on the real rates of ex- rule cases, (Figure 3 and Figure 4). change rate robustness.

In relation to the volatility of the macroeco- nomic variables considered in this analysis, in

Monetary policy shock

contrast to shocks to monetary policy, consump- Consider a positive shock to monetary policy tion, CPI inflation, and intermediate output pro- which implies a tightening of the monetary pol- duction seems to fluctuate less in case 2 then in icy stance. With a shock resulting in a monetary case 1.While the real exchange rate seems to fluc- policy tightening, domestic interest rate (r) rose tuate more in case 2 than in case1. Thus this indi- and consumption (c) and inflation rate (pi) fell cate that, with the exception of the real exchange before returning to its steady state level in both rate, a more flexible exchange rate seems to pro- cases. Also in both cases the real exchange rate ap- vide lower volatility of macroeconomic variables preciated before going to steady state. The reason for the case of shocks to foreign inflation. for this is that the positive monetary policy shock which result in the increase in the domestic inter-

CONCLUSION

est rate result in capital inflow, which hence would induce the appreciation of the exchange rate. In

By specifying a financial accelerator model addition to this, consumption fell and investment with liability dollarization with balance sheet ef-

rose. The reason for this result is that due to the fect and imperfect international substitutability of rise in the domestic interest rate, this induce sub- assets, it can be observed that there are variations stitution away from current consumption towards in the volatility of the macroeconomic variable future consumption, and thus investment (see ap- under consideration for the two monetary policy pendix).

rule cases analyzed in this paper. However the re- Observing the fluctuations of impulse respons- sults from this paper seems to indicate that the im-

es of the macroeconomic variables considered, it pact of the two monetary policy rules under con- can be seen that the changes in consumption, do- sideration in the fluctuations of macroeconomic mestic interest rate, and output higher in case 1 variables is not symmetric. With monetary policy than in case 2. This might indicate that a more sta- shocks, a monetary policy rule with a more stable ble real exchange rate might provide lower fluc- real exchange rate seems to provide greater sta- tuations of macroeconomic variables in relation to bility of the macroeconomic variables under con- monetary policy shocks.

sideration. In contrast the same cannot be said for technology shocks and foreign price shocks.

Jurnal Ekonomi Manajemen & Bisnis - Vol. 19, No. 1, April 2018

x 10 0.01 -3 y 5 pi

Figure 1. Technology shock (case 1)

Figure 2. Technology shock (case 2)

Figure 3. Foreign inflation shock (case 1)

Figur 4. Foreign inflation shock (case 2)

88 TAUFIQ CARNEGIE DAWOOD

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