Double Drain, Risk of Recession and Monetary Policy in Small Open Economies

Transcription

1 Double Dran Rs of Recesson and Moneary olcy n Small Open Economes GEU-OUG KIM IMER he Ban of Korea Absrac. hs paper examne he moneary polcy mplcaons for emergng economes experencng double drans ha s cred crunches n boh he global and her domesc fnancal mares. We consruc a wo-secor small open economy model wh feaures such as orgnal sn and dollar prcng whch are relevan o emergng mares. Our resuls mply ha n decdng s polcy sance he moneary auhory should consder he exen o whch nernaonal shocs are ransmed n he domesc cred mares. When nernaonal fnancal shocs h he economy whou spreadng by conagon o domesc fnancal nermedaon he polcy neres rae ncreases and he economy reduces s exernal debs and expands s ne expors whle he conracon n real economc acves s mgaed by reallocaon of npu resources no he raded secor. However f he nernaonal shoc s conagous and domesc fnancal mares hence dp no a cred crunch he polcy neres rae may be lowered o buffer he common negave mpacs n boh he raded and non-raded secors dependng upon he degree of conagon. o mnmze he cos of recesson followng an nernaonal fnancal shoc a passve sance for an exernal dran whou conagon and an acve sance under a double dran wh conagon are desrable. Keywords: Exernal Dran; Double Dran; Recesson; Moneary olcy; Small Open Economy JEL classfcaon : E5; E3; F4 Address for correspondence : Insue for Moneary and Economc Research he Ban of Korea Republc of Korea. E-mal : gy34@bo.or.r. I wsh o han he BOK s commee Seunge Hong Junhan Km Byoung-K Km Kyungsoo Km Mchael Huchson oung-kyung Suh and an anonymous referee for her helpful commens. I also han semnar parcpans a he Ban of Korea and a he AEA 29 conference.

2 2. IRODUIO he recen fnancal urmol orgnang from he U.S. sub-prme morgage crss has been affecng many emergng economes especally hose wh heavy dependence on exernal borrowngs. Fnancng from nernaonal capal mares gves hese emergng counres opporunes o acheve hgher economc growh bu excessve dependence on hs exernal source of fundng also enals some rs of economc desablzaon. apal nflows may suddenly urn no capal ouflows whch can easly cause nsably of he fnancal and real secors n hese emergng economes. As shown n Fgure durng a perod of sudden capal flow reversal emergng economes are lely o experence a rapd deeroraon n condons for obanng new foregn loans or rollng over exsng borrowngs. In hs suaon hey need o reduce her ousandng soc of foregn debs by runnng curren accoun surpluses generally accompaned by sharp reducons n oupu and employmen. Fgure. Sudden Sop and DS remum n Korea. he desgn of opmal polcy responses o adverse exernal fnancal shocs durng a perod of global capal mare urmol represened by a sudden ncrease n premums on nernaonal borrowng wh a sharp rerenchmen n capal alvo 998 used he erm sudden sop for hs phenomenon of capal reversal. Some people dfferenae beween sudden flghs whch means surgng nvesmen abroad by domesc resdens and sudden sops n capal nflows by foregn nvesors. Deeroraon n he capal accoun n a counry can be caused by hese wo effecs ogeher.

3 nflows has been an mporan ssue parcularly snce global fnancal nsably swep across he world economy recenly. he man queson for he polcy auhory s "Should a counry facng a fnancal shoc on foregn borrowng ghen s moneary polcy?" Or "Should relax s polcy sance n order o aenuae he conracon n oupu?" here are wo possble bu oppose vews. he frs vew s ha moneary polcy n he afermah of a large exernal shoc n capal nflows should become gher n order o avod poenal macroeconomc and fnancal nsably and resore credbly. In he second vew ohers have argued ha moneary polcy should be expansonary under a sudden sop shoc n order o buffer agans a severe economc downurn. here are several heorecal papers on opmal moneary polcy durng a perod of fnancal urmol. Braggon hrsano and Roldos 27 consruc a model where an nal ghenng followed by a laer loosenng s opmal. her argumen reles on he need o avod currency msmaches n he very shor run whle easng hem n he medum erm. Heva 27 suggess ha a conraconary moneary polcy s welfare mprovng. He menons ha when here s fnancal ghenng on a counry's foregn borrowng he counry s requred o run a curren accoun surplus. In hs model here are declnes n he producon of fnal goods consumpon and nvesmen and a reallocaon of npus o he radable secor. he opmal drop n consumpon and he rgdy of prces mply ha money supply should be ghened. úrda 27 also shows ha opmal moneary polcy nduces an neres rae he and an exchange rae deprecaon. he neres rae he dscourages borrowng and consumpon mgang he mpac of he ncreased cos of borrowng. he exchange rae deprecaon provdes a boos o expor revenues reducng he need for a domesc recesson. Some auhors examne emprcally he effecveness of moneary polcy durng perods of sudden reversal n capal flows. Huchson e al. 27 nvesgae 83 sudden sop crses n 77 counres over 982~23 and fnd ha moneary and fscal ghenng a he me of a sudden sop crss sgnfcanly worsens oupu losses. Orz e. al. 27 also analyze he fscal and moneary polcy responses and her effecs on oupu n a se of 22 exernal fnancal crss epsodes occurrng snce 99. hey fnd smlar evdence ha counres whch ghened moneary and fscal polcy durng hese crses experenced larger oupu conracons han counres ha followed looser polcy sances. In hs paper we argue ha n explorng he desrable moneary polcy sance n response o an exernal shoc wh subsanal deeroraon n he cos of foregn borrowng mgh be mporan o dsngush wo possble suaons; an exernal dran case n whch he cos of borrowng from abroad surges and a double dran case n whch an nernaonal fnancal shoc s conagous hus causng an nernal dran wh a domesc cred crunch. Alhough here s no ex-ane reason o expec occurrence of such a domesc cred crunch followng an 3

4 4 global fnancal shoc domesc mare fnancng condons end o ghen under hs exernal shoc n many emergng economes. hs double dran a combnaon of he exernal dran caused by deeroraed foregn borrowng condons and he nernal dran semmng from domesc cred crunch - s an neresng feaure n emergng mares durng perods of fnancal urmol 2. In Fgure 2 we can observe ha Korea experenced hs double dran phenomenon recenly. bp 45 %p DS remumlef Lendng Rae-Depos RaeRgh Fgure 2: Emprcal Evdence of Double Dran n Korea.. We focus on hs double dran aspec n he recen fnancal urmol and examne s mplcaons for moneary polcy. We consruc a small open dynamc general equlbrum model whch ncludes a banng secor and he feaures of emergng economes - orgnal sn dollar prcng n exernal rade and worng capal consrans. We hen compare wo cases: an exernal dran case whou conagon and a double dran case wh conagon focusng on he moneary polcy responses n erms of reducng he cos of recesson. Under a double dran he producvy of a ban's nermedaon echnology s affeced by nernaonal shocs so ha s neres rae on deposs borrowng rae may dffer from he neres rae on s loans lendng rae generang an neres rae spread. he man fndngs are as follows: If here s no conagon effec from nernaonal fnancal shoc on domesc fnancal nermedaon he polcy neres rae mus rse under an exernal premum shoc wh a decrease n foregn debs and mprovemen of ne expors whle real oupu conracs less owng o reallocaon of npu from he non-raded secor o he raded secor. However n he case of a 2 he erm double dran was used n Mller o refer o a suaon n whch a currency banng crss can cause a banng currency crss when banng sysem s wea.

5 5 double dran wh a domesc cred crunch mgh be desrable for he moneary auhory o respond by lowerng he polcy neres rae dependng upon he sze of he conagon effecs. In order o mgae he cos of conracon n oupu herefore a passve acve sance n moneary polcy s desrable for he exernal dran double dran case. he paper proceeds as follows: Secon 2 descrbes he model afer whch he equlbrum condons are derved n Secon 3. In Secon 4 he man resuls of moneary polcy mplcaons under he wo cases ogeher wh robusness analyss and some dscussons are presened. Secon 5 concludes. 2. HE MODEL We consder a small open economy model augmened wh fnancal frcon n he form of a deb-elasc rs premum on exernal funds and producvy n ban fnancal nermedaon. hs economy borrows from nernaonal capal mares n foregn currency subec o a counry rs premum. Unexpeced fnancal shocs orgnang from he nernaonal capal mares may affec he domesc real and fnancal economes. he economy conans fve ypes of agens: a represenave household a fnshed goods-producng frm a connuum of nermedae goods-producng frms ndexed by [] a represenave ban and a moneary auhory. 2.. he Represenave Household Each household s nfnely lved and has dencal preferences defned over consumpon of a base of fnal goods and lesure a every dae. A represenave household s assumed o maxmze he followng neremporal lfeme uly funcon: Max E β U ϕ σ U σ where E s he expecaon operaor a me β s he subecve dscoun facor denoes a compose consumpon ndex denoes labor effor σ s he neremporal elascy of subsuon n consumpon and ϕ > s he elascy of subsuon beween consumpon and lesure. he household s assumed o consume raded and non-raded fnal goods. he compose consumpon ndex s defned as

6 6 ] [ η η η η η η η η α α 2 where > η measures he elascy of subsuon beween raded and non-raded goods and ] [ α measures he share of raded goods n he compose consumpon ndex. he wo consumpon sub-ndexes of raded and non-raded goods and are symmerc and hey are gven by he ES funcon: } { d } { d where > s he prce elascy of demand ] [ denoes he varey of goods and and are he quanes purchased by home agens of raded goods and non-raded goods respecvely. he overall prce ndex I s defned as η η η α α ] [ 3 where d and d are he raded goods and he non-raded goods prce ndexes n he domesc currency respecvely. Households' opmal allocaon whn each caegory of goods s gven by he followng demand funcons: Usng he defnon of oal consumpon n 2 we can derve he opmal allocaon of expendures beween raded and non-raded goods: η α η α 4 oal consumpon s hen reduced as follows: 5 he household owns he domesc fnal goods producers and accumulaes physcal

7 7 capal. he laws of moon of he capal soc n he wo secors are gven by: K K I δ K K δ I 6 where I s he gross nvesmen and δ s he rae of capal deprecaon. he household begns he perod wh M - un of money and mus decde how o dvde s funds no an amoun D o be deposed n he represenave ban and an amoun M - - D o be used o faclae goods purchases. Represenave agen faces he followng budge and cash n advance IA consrans: I I M D F S Ψ 7 d F B S F M D W Q K Q K Π Π M D W 8 he rgh hand sde of equaon 7 represens he resources he consumer has a hs dsposal a he begnnng of perod. hese conss of wage earnngs W obaned by supplyng hs labor servces o he frm renal earnngs Q K on capal n boh secors he shares of profs Π from frms and bans and he amoun of foregn currency-denomnaed deb F. s he nomnal exchange d rae defned as uns of he home currency per un of foregn currency and denoes he nomnal neres rae earned on deposs. We assume he deposs are pad bac n he same perod n order o avod real balance frcons relaed o consumpon n he money mare. he lef hand sde corresponds o he uses of hese resources. he household can use hese o consume goods accumulae capal pay bac he exernal deb F borrowed and depos D wh he fnancal nermedary. Ψ s he co unry rs premum on exernal borrowngs and s he foregn neres rae. he IA consran 8 mposes he condon ha he household need o allocae money balances and labor earnngs for consumpon ne of deposs has decded o allocae o he fnancal nermedary. onsumpon and nvesmen are defned as a nesed ES combnaon of domescally produced non-raded goods and domescally produced raded goods. raded and non-raded goods are combned no a quany of goods absorbed :

8 8 η η η η η η η η I I A [ α A α A ] 9 A η η α A A α A he household chooses he pahs of { K K M D F} o maxmze s expeced lfeme uly. he frs-order condons can be summarzed by : W ϕ ϕ d ϕ βe [ ϕ ] 2 S Ψ E d S 3 E [ Q d δ ] 4 E [ Q d δ ] he Represenave Ban he role of he ban s o ae deposs from households and lend o frms. he banng ndusry s assumed o be perfecly compeve. A he begnnng of perod he represenave ban acceps deposs D from he represenave household and provdes lendng servce L o each domesc nermedae goods and non-rade goods producng frm subec o he lnear producon funcon: L φ D 6 where φ represens effcency n banng echnology. l s he ban collecs L of prncpal and neres from each nermedae goods-producng frm and repays he neres for he money deposs by he household a he end of perod. he ban's problem s: where s.. L B Max E D L φ D B Λ Π Π D D L L 7 d σ

9 9 he opmaly condons for he ban's deposs and loans are as follow: d l φ 8 L φ D 9 for all 2... l As long as he ne nomnal neres rae s posve he ban wll lend all of s funds and eq.6 wll hold wh equaly bu faces uncerany n he producvy of fnancal nermedaon. herefore f here s a negave shoc o producvy of cred servces he oal amoun of lqudy suppled by bans wll decrease and he lendng rae wll exceed he depos rae Frms raded goods secor Focusng on a small open economy whch depends on boh s expors of fnal goods and mpors of nermedae goods 3 s assumed ha frm ransforms domesc and mpored nermedae goods bundles no a dfferenaed raded good usng a ES echnology: τ τ τ τ τ [ γ IMD γ IMR ] < τ < γ < τ τ τ 2 Where IMD and IMR represen he domesc and mpored nermedae goods respecvely. Domesc nermedae goods are produced usng capal and labor npus wh a obb-douglas producon funcon: α α IMD K < α 2 < where K and denoe he amouns of capal and labor used by he frm n he raded secor. We have wo assumpons as o he frm's producon: he worng capal consran and orgnal sn expressed as follows: 3 In many prevous wors s assumed ha a small open economy mpors and also expors nermedae goods bu our srucure s more realsc for he analyss of many expor-led developng counres. Mcallum and elson 2 also poned ou ha reang mpors as nermedae npus raher han fnal consumpon goods mproves he emprcal f of open-economy models.

10 W Q K L 22 F IMR F 23 I s assumed ha he frm mus borrow funds L from bans o pay s wages and renal on capal. he margnal coss of employng addonal uns of labor l l and capal are hen W and Q. When he ne nomnal neres rae l s posve hs fnancal consran holds wh equaly. In hs case f he frm chooses he opmal amouns of labor and capal npus he amoun of borrowng demand from he ban L s deermned gven he wage and he renal rae. Furhermore hs economy canno borrow n s own currency and so mus borrow foregn currency deb o purchase he mpored nermedae goods a consran commonly nown as orgnal sn of emergng economes 4. he manufacurer purchase he mpored maerals wh foregn currency borrowed a he rae of Ψ ; hence he margnal cos of employng an addonal un of he mpored nermedae goods s Ψ S F n whch a hgher exernal rs premum wll adversely affec he purchases of mpored maerals. he frs-order condons of he frm's problem are: I D α K W α Q 24 τ IMD I τ γ [ ] Ψ S 25 l l Q [ W ] α α α α α 26 τ τ τ { γ I D γ[ Ψ S ] } I 27 where I and I D are he producer prces of raded goods and of domesc nermedae goods respecvely and s he foregn currency prce of mpored maerals. F on-raded goods secor 4 he erm orgnal sn was used frsly n Echengreen and Hausmann999 who refer o wo ypes of orgnal sn: Inernaonal orgnal sn - he nably o borrow n erms of he domesc currency - and domesc orgnal sn - nably o borrow long erm domescally. Reference o orgnal sn n mos of he recen leraure usually mples he frs meanng.

11 rce-ang non-raded goods producers use labor and capal o produce goods sold a prce I : α α K 28 wh he same worng capal consran: W Q K L 29 he frs-order condons of he frms' prof-maxmzaon problem for he choces of labor and capal are: α K W α Q l l α α 3 I Q [ W ] α α 3 α n omnal Rgdy Regardng he frm's prcng behavor emprcal research on many small open economes shows ha mos frms se her prces n erms of a maor currency e.g. he U.S. dollar euro or yen n boh mpors and expors. In order o ncorporae hs real feaure n our model we consder asymmerc prcng behavor.e. local currency prcng L n he expor secor and producer currency prcng n he mpor secor. here are hree ypes of scy prces: he real prces of non-raded goods he domesc real prces of raded goods and he foregn currency prces of expored goods. he dynamcs of each of hese prces follow a smlar framewor. For each here s a range of monopolscally compeve realers who purchase an undfferenaed npu good em.e. raded or non-raded from manufacurers and face a consan elascy demand curve. Followng alvo 983 each realer s assumed o face a consan probably n every perod of reseng s prces n he domesc and foregn mares. Under hs prce seng srucure equals wh probably 2... When seng a new prce n perod realer sees o maxmze he expeced dscouned value of profs. he expeced prof of domesc raded goods realers s: Max E Λ H { M }

12 2.. A s where s he rao of margnal uly beween perods Λ and. By he frs order condon and mposon of symmery he opmal prce for domesc mares mus sasfy he followng condon: } { Λ M E Rewrng hs n erms of opmal prce we oban E M E Λ Λ A where Subsung he dscoun facor he opmal prce for domesc mares s as follows: / / U U Λ β E M E β β 32 whch mples ha he new prce se by frm a perod s a marup over he expeced fuure margnal coss. If prces are perfecly flexble he marup s a consan and equal o. Wh scy prces he marup becomes varable over me when he economy s h by exogenous shocs. he defnon of he prce ndex d mples ha s law of moon s gven by ] [ 33 Analogously we can oban a smlar opmal prce equaon for he non-raded goods:

13 3 E M E β β 34 A where ] [ 35 In he expor mares exporng realers purchase domescally produced goods and sell hem as dfferenaed expor goods n foregn mares by seng her prces n foregn currency. he opmzaon problem of he exporng realers s } M S E Max Λ o subec he new opmal expor prce a perod charged n he foregn mare s: x x S E M E β β 36 H where he prce ndex of expor goods s: ] [ x x 37 If some frms canno change her prce > x whch means exchange rae pass-hrough s mperfec he expor prce wll adus only gradually o devaon from he law of one prce. We assume n he mpor secor ha he domesc prce of mpored nermedae goods s he foregn currency prce whch s deermned exogenously o hs economy mes he nomnal exchange rae he enral Ban's Moneary olcy Moneary polcy formulaon by he domesc cenral ban follows a generalzed rule n whch devaons of nflaon and gross domesc produc from her long-run arges have F IMR S A S A GD

14 4 a feed-bac on shor-run movemens of he nomnal neres rae 5. he followng equaon descrbes he arge for he nomnal depos neres rae: log d d π GD μ log μ[ Φ log Φ log ] 38 π y ı ı π GD where μπ and GD are he neres rae smoohng parameer he arge level of he nflaon rae π and GD respecvely. 3. AGGREGAIO AD EQUILIBRIUM ODIIOS 3.. Goods Mares Aggregang over all frms yelds: K K d d IMD IMD IMR IMR d d and he producon echnology n each secor s: τ τ τ τ τ τ τ τ [ γ IMD γ IMR ] < τ < γ 39 < IMD K α α < α < K α α < α < In a symmerc equlbrum we have 4 4 I D α K α α α K W Q W Q τ IMD τ γ [ I ] Ψ S 44 l l Q [ W ] α α α α α 45 5 Insead of hs aylor ype polcy rule we may consder alernave moneary argeng rule n whch cenral ban decdes he growh rae of money supply. Here we consder depos neres rae as a moneary polcy nsrumen and money supply us mees money demand gven he level of he neres rae.

15 5 τ τ τ γ γ Ψ } ] [ { D S I I 46 ] [ n l l W Q I α α α α α 47 he demand for good s he sum of he demand from domesc and foregn consumers: A I ] [ Aggregang over monopolsc domesc goods realers yelds he overall domesc fnal goods mare equlbrum equaon: A Δ Δ 48 A Δ 49 5 where d Δ s a measure of relave prce dsperson n he domesc and expor goods secors ndcang ha purchases of good mus depend only upon he prce charged on hose goods and he overall dsrbuon of prces charged. We can rewre he prce dsperson ndexes 6 n erms of alvo relave prces as he followng law of moon: Δ Δ 5 Recallng ha ] [ and dvdng boh sdes by we have 52 whch mples 6 Woodford defned a measure of prce dsperson n he alvo model as a cross-secon varance of logarhms of ndvdual prces.e log var p Δ. For a dealed dscusson see Woodford 23 ch.6 p.399.

16 6 53 By pluggng eq. 53 no eq. 5 we oban Δ Δ π π 54 where π whch mples ha he curren level of he measure of relave prce dsoron depends upon he curren rae of nflaon and he prevous level of he measure of relave prce dsoron. By subsung profs from he ban and frms no household budge consran eq. 7 and rearrangng we oban he counry's resources consran as follows: F IMR S A S A F S S F I I * * Ψ Exernal Secor I s assumed ha expors are lned o relave prces and he res of he world's ncome by he followng law of moon. 2 ϑ ϑ 56 where s he seady-sae value of expors e expor prce of domesc goods and s he expor prce se by foregn compeors. s h e expors n real erms can be expressed as: { I S A A IMR S }/ Ψ 57 Subsung eq. 57 no he counry's resources consran we ge he followng balance of paymens equaon whch saes ha he ne foregn asses poson changes wh accrung neres and he ne expors :

17 7 F F * Ψ 58 S 3.3. red Mares In he cred mare demand for loans and supply of loans should be equal n equlbrum: L L W W Q K Q K Exogenous Shocs L L L d L L d We assume ha a rs premum Ψ s composed of a varable componen and an exogenous shoc o he rs premum ν followng an AR process: Ψ exp S F SF ν 6 Daa on bond yelds show ha he premums on bonds ssued by emergng mare counres rse dramacally durng he perod assocaed wh reversals n capal nflows o hese economes. Followng oo and Devereux 26 we model sudden fnancal urmol orgnang from global fnancal mares as unexpeced exogenous shocs o he counry rs premum on borrowng from abroad ν followng an AR process: ν ν 2 ν ρν ν ρνν d σ v 6 We assume ha exernal dsurbances caused by rs premum shocs can affec he effcency of fnancal nermedaon. In pracce bans mus carry ou a varey of cosly acves evaluang credors managng deposs renng buldngs mananng AMs ec. o manan a gven level of loans and deposs and he coss of hese acves end o be hgher effcency ends o be lower n a perod of fnancal urmol 7 whch can be expressed as: v φ ρ φ ρ φ ω ω 62 φ I s assumed ha he share of he small economy's goods consumed n he res of he world s neglgble whch mples ha a small open economy canno affec he φ 7 Refer o Edwards and Vzgh 997: Durng fnancal crss bans are requred o spend more effors o monor her cusomer frms so producvy ends o be lower han n normal economc condons.

18 8 world prce and F and demand. Hence he wo foregn aggregaes are assumed o be exogenously gven: log log ρ log ρ log ρ log ρ log p p p where and are ndependen whe noses wh fne sandard devaons Equlbrum for he Model Gven he above equlbrum condons we ransform all nomnal varables no real erms by dvdng by. An equlbrum for hs model s a sequence of prces and allocaons d l { π π π Ψ W I I I D Δ S Q Q F L L L K K I I IMR IMD } such ha for each me perod he opmaly condons of he represenave household ban and frm hold and all mares clear. 4. RESULS: IMLIAIOS FOR MOEAR OLI 4.. ransmsson channel When a shoc o he rs premum on exernal borrowng hs he economy domesc fnancal mares may or may no face cred crunches n accordance wh he overall soundness of he banng ndusry macroeconomc condons expecaon of he severy of he shoc ec. We dsngush a double dran case wh a domesc cred crunch from he exernal dran case whou conagon sudden sop shoc only; ha s producvy n he ban's fnancal nermedaon echnology s assumed o be affeced by he shoc from nernaonal capal mares under a double dran as follows 8 : p 8 As well summarzed n Adran and Shn 28 he leraure has denfed wo dsnc channels assocaed wh he shoc ransmsson. he frs s he ncreased cred ha operaes hrough he borrower's balance shee where ncreased lendng comes from he greaer credworhness of he borrower Bernane and Gerler 989. he second s he channel ha operaes hrough he bans balance shees eher hrough he lqudy srucure of her balance shees Bernane and Blnder 988 Kashyap and Sen 2 or hrough he cushonng effec of her capal Van den Heuvel 22. Durng he recen global fnancal crss Korean domesc bans suffered from foregn currency fundng lqudy shorage due

19 9 v v ω z f z > : double dran case z : exernal dran case 63 where z s he degree of conagon parameer and s he me lag Exernal Dran ase whou onagon Under he case of no conagon here are wo effecs of he rs premum shoc on hs small open economy. Under a shoc o he rs premum domesc neres raes may rse or drop dependng upon he effecs of he shoc on nflaon and oupu gap. he exchange rae can also eher apprecae or deprecae n lne wh he relave adusmen n he domesc neres rae. If he domesc neres rae ncreases less more han he exernal fundng cos he exchange rae should deprecae apprecae whch can be seen from he rs premum augmened uncovered neres pary UI condon. hs economy mus mpor nermedae goods from abroad wh foregn currency orgnal sn so an ncrease n he cos of foregn borrowng and exchange rae deprecaon can reduce he amoun of mpored nermedae goods hrough ncreasng n he un cos for he addonal foregn npu. In he raded goods secor a decrease n mpored nermedae npu causes a declne n producon of raded goods even hough here mgh be some subsuon effecs of reallocang capal and labor npus no he raded secor from he non-raded secor. hs case of no conagon s smlar o he suaons descrbed n Eledag and charov 27 and Gerler Glchrs and aalucc Double Dran ase wh onagon Wha f he domesc fnancal condons are ghened due o a sudden capal reversal shoc? When producvy n he fnancal nermedaon funcon o maury and currency msmaches and ghened her domesc lendng sances n consderaon of he necessy of bufferng agans hese lqudy shorages for repayng foregn currency deb and agans he possbly of balance shee deeroraon of frms usng foregn borrowngs. Hence he frs and second channels mgh boh be relevan ogeher. 9 We se he sze of he domesc cred crunch shoc when we examne he baselne double dran case.e. z so ha he deph n he response of oupu a he rough o a one sandard devaon cred crunch shoc s equal o ha under he exernal dran case. he me lag parameer s se o zero n our quarerly model because he conagon acually ends o occur n a shor perod.

20 2 deeroraes he loan neres rae s hgher han he depos rae;.e. here are addonal effecs caused by he spread beween loan and depos neres raes as well as he effecs n he exernal dran case alone. Hence he cos of hrng labor and capal npu n boh he raded and he non-raded secors ncrease and oupus n boh secors hen decrease. hs cred crunch shoc under a double dran s common o boh he raded and he non-raded secors. Exernal Dran ase ED : Double Dran ase ED addonal nernal dran channel : Fgure 3. Shoc ransmsson hannel under wo ases arameerzaon We assgn a value of.99 o he subecve dscoun facor β 2. o he neremporal elascy of subsuon of consumpon σ and.5 o he elascy of labor supply parameer ϕ. I s assumed ha he annual deprecaon rae s % whch maes δ.25. hese values are commonly used n he leraure. We calbrae he values of oher parameers o mach Korean economc daa. We have chosen as he prce elascy of demand whch mples a prce mar-up of %. he elascy of subsuon beween home and foregn goods η s se o 5 and he coeffcen of he rs premum s se o.4. For he parameers ϑ and ϑ 2 n he res of world demand for domesc goods he share of mpored consumpon goods α he capal shares n he raded and non-raded secors α and α and he degree of neres rae smoohng μ are also se o mach he daa. We se.75 as he degree of prce scness parameer n he domesc and expor mares. We choose he parameer λ so ha a one sandard devaon shoc o he rs premum and a domesc cred crunch can nduce he same deph n response of oupu a he rough n he baselne sance.

21 2 able. arameers of he Model. arameer Value arameer Value β.99 σ 2 δ.25 ϕ.5.75 α.3 η 5 ϑ -.88 ϑ 2.5 α.3 α.25 κ.4 τ.5 μ.69 ρ ν.9 ρ φ.9 σ v Moneary olcy Sance In hs secon we compare fve cases wh dfferen ses of polcy parameers beng able o represen ey moneary polcy sances. We consder a baselne sance n whch he polcy parameers φ π.5 φ y.5 are aen from he values n he prevous leraure as well as four oher dfferen polcy sances: an an-nflaon sance an an-oupu gap sance an acve response sance 3.. and a passve response sance By comparng hese polcy sances we deermne whch moneary polcy sance s desrable under wo dfferen cases - an exernal dran and a double dran - n erms of mnmzng oupu loss. able 2. Represenave Moneary olcy Sances. M sance Base Acve assve An-Infla An-gap Ф п For example oo and Devereux 27 and Eledag and chaarov 27. Our approach s dfferen from mos of he prevous leraure on opmal moneary polcy n whch he goal of he moneary auhory s o search for a welfare maxmzng polcy rule under uncerany due o exogenous shocs. We focus on oupu loss because he rs of recesson ends o be he man concern for polcymaers n mos counres afer global fnancal urmol has once eruped.

22 22 Ф y Oupu oss wh Varous Moneary olcy Sances Exernal drans n emergng mares appear o have been rggered by subsanal deeroraons n exernal deb premums and massve capal ouflows and hese exernal drans end o be followed by conracons n he real secor n many cases. For example Huchson and oy 26 nvesgae wheher sudden-sop crses are unque phenomena and wheher hey enal especally large and abrup paerns of oupu collapse usng a panel daa se over 975~997 coverng 24 emergng-mare economes and fnd ha sudden-sop crses have a large negave bu shor-lved mpac on oupu growh. If an exernal dran causes a cred crunch n he domesc cred secor hs may lead o a furher conracon n oupu. Hence when nernaonal capal nflows suddenly sop and he cos of foregn borrowng rses sharply one of he man concerns of polcymaers s how o preven or mgae he severy of conracon or recesson n real economc acves. If he man obecve of he moneary auhory s o mgae he negave mpacs of an exernal rs premum shoc on oupu he more effecve polcy sance mgh dffer dependng upon he possbly of conagon Exernal Dran ase In <able 3> we compare he oupu coss of dfferen moneary polcy sances n he case of exernal dran whou conagon. he oupu cos of a specfc case s calculaed as he mean level of real oupu for hree years afer a one sandard devaon exernal rs premum shoc hs he economy. 2 Under he baselne sance average oupu cos s -.8% of he seady sae oupu level. he passve moneary polcy sance wh weaer polcy parameers φ π.25 φ y.25 s preferable o he acve polcy sance n erms of oupu cos -.7%. he acve polcy sance leads o he larges oupu losses -.% wh bg drops n mpored nermedae goods and domesc loans. Beween he an-nflaon and an-oupu sances he an-nflaon sance produces a lle less oupu cos. In he passve sance he average level of he polcy neres rae s hgher and he real exchange rae s slghly lower mplyng ha he cos of fnancng mpored 2 We choose hree years for calculaon of oupu cos because n mos cases aes hree years for he economy o recover from conracons due o he mpac of a shoc. We also conduced robusness checs wh dfferen me horzons.

23 23 nermedae goods ncrease less. As a resul he average level of domesc loans and mpored npus decrease o lesser exens and he mpac of he exernal rs premum shoc on real oupu s mgaed. able 3. Oupu oss under Varous olcy Sances: Exernal Dran ase. Φ π Φ y ED BASE ED AIVE ED ASSIVE ED An-Infla ED An-gap Mean % R IF IV Loans / F/ RER S.D. % R IF IV Loans / F/ RER Double Dran ase If he domesc cred mares are affeced drecly by an nernaonal rs premum shoc he mplcaons of a parcular polcy sance may dffer from hose under he exernal dran case. <able 4> ndcaes ha an acve polcy

24 24 sance n whch he moneary auhory responds o nflaon and he oupu gap more aggressvely leads o he bes oucome -.23% of oupu loss alhough under all polcy scenaros he degree of oupu conracon expands more han under he exernal dran case. An an-nflaon sance brngs abou he larges oupu loss -.38% whle an an-oupu gap sance has he second bes oucome. Under boh he acve and an-oupu gap sances he average polcy neres rae level s lower and domesc loans and mpored nermedae goods decrease less. able 4. Oupu oss under Varous olcy Sances: Double Dran ase. DD BASE DD AIVE DD ASSIVE DD An-Infla DD An-gap Φ π Φ y MEA % R IF IV Loans / F/ RER S.D. % R IF IV Loans / F/ RER Impulse Responses under olcy Sance Mnmzng Oupu Loss

25 25 In hs secon we compare he mpulse responses of he macro varables under wo cases hose of he opmal polcy sances whch can mnmze oupu losses n he exernal and he double drans scenaros. he overall paerns of mpulse responses n he model concde wh hose of emprcal analyss wh Korean daa 3 mplyng ha our heorecal model s vald Exernal Dran ase whou onagon When he economy s h by an exernal rs premum shoc he polcy neres rae ncreases and he real economy conracs whle ne expors mprove and foregn deb decreases. he reasonng behnd he polcy responses s as follows. he exernal rs premum shoc s a negave shoc n ha ncreases he cos of acqurng mpored nermedae goods necessary for producon by he assumpon of orgnal sn. hs mples ha here s a conracon n he fnancal accoun ha needs o be mached wh an ncrease n he curren accoun. In hs case he exogenous shoc s secor specfc;.e. manly affecs he raded good secor. Hgher neres raes play a role n gvng he economy a buffer agans he shoc by reallocang npu resources from he non-raded o he raded goods secor. hs resul s on he same lnes as Heva 27 and urda 27. I s noeworhy ha he bgger he sze of he rs premum shoc he hgher he neres rae response as shown n Fgure 4. In conras o urda 27 he real exchange rae apprecaes slghly n he presen model and he adverse effec caused by a bgger burden of mpors can hence be suppressed whle expors are no so much affeced gven he assumpon of local currency prcng n he expor secor. 3 See appendx for he resuls of emprcal mpulse response analyss.

26 x -3 RD x -3 RL x -3 Real E IMR / Ex. Deb E.D. wh s.d. shoc E.D. wh 2 s.d. shoc E.D. wh 3 s.d. shoc Fgure 4. Impulse Responses under Exernal Dran ase Double Dran ase wh onagon Wha f he nernaonal shoc s conagous o he domesc cred mares? In Fgure 5 we compare he mpulse responses of hree dfferen cases n erms of he degree of conagon from nernaonal rs premum shocs causng domesc cred crunch. he more he effcency of fnancal nermedaon s affeced by an exogenous rs premum shoc he more lely s ha real economc varables conrac ne expors mprove and exernal deb s repad. However he polcy neres rae moves lower wh sronger conagon effecs n conras o he case wh no conagon.

27 x -3 RD 5 5 IMR RL / Real E DD wh Z DD wh Z2 DD wh Z3. -. Ex. Deb Fgure 5. Impulse Responses under Double Dran ase Robusness of Resuls In hs secon we examne he robusness of he resuls n erms of wo aspecs - he ne foregn asse poson whch would have mporan mplcaons for small open economes and he role of he me horzon n comparson of polcy sances Role of ne foregn asse poson In he baselne scenaro we assgn.27 for he seady-sae value of ne foregn asses followng he fac ha Korea remaned a credor unl erupon of he global fnancal crss. We change he value n wo drecons so ha we can verfy wheher he resuls formed above change n a case wh hgher ne foregn asses or ne foregn deb. As shown n <able 5> our prevous resuls reman n whch a passve sance s desrable n he exernal dran case and an acve sance n he double dran case even hough he oupu loss becomes larger wh hgher lower ne foregn deb asses. hs mples ha he adusmen mechansm of hs economy does no change fundamenally due o varaon n he level of ne foregn asses under eher he exernal dran or he double dran case.

28 28 able 5. Robusness wh Dfferen e Foregn Asse osons ED BASE AIVE ASSIVE An-Infla An-gap Φπ Φy Mean % Hgher FA Fss IF Loans Mean % e Foregn deb Fss IF Loans DD BASE AIVE ASSIVE An-Infla An-gap Φπ Φy Mean % Hgher FA Fss IF Loans Mean % e Foregn deb Fss IF Loans

29 me dmenson of oupu loss In he prevous secon we calculaed oupu losses over hree years n consderaon of he mpulse responses n whch he man macro varables reurn o he seady sae value abou hree years afer he shoc hs he economy. Bascally he proper me horzon for he moneary auhory would be relaed o he perssence of he shoc;.e he more perssen he shoc s he longer he me horzon ha should be consdered as wll ae more me for he economy o recover from a more perssen exernal shoc. For robusness chec we recalculae he oupu cos over wo dfferen horzons wo years and wo and one half years n consderaon of he facs ha ey varables such as oupu and labor seem o reurn o he seady sae n shorer perods han hree years dependng upon he moneary polcy sance. We fnd ha he man resuls do no change.e. he bes moneary polcy sance remans as shown n able 6: able 6. Robusness wh Dfferen me Horzons ED BASE AIVE ASSIVE An-Infla An-gap Φπ Φy Mean % me Horzon wo ears IF Loans me Horzon wo and one-half ears IF Loans DD BASE AIVE ASSIVE An-Infla An-gap Φπ Φy Mean % me Horzon wo ears

30 3 IF Loans me Horzon wo and one-half ears IF Loans Dscusson: Why Are Dfferen olcy Responses Requred? In he prevous secon we found ha he queson of wheher fnancal nermedaon of domesc bans s affeced by an nernaonal fnancal shoc or no could be mporan n decdng he sance of moneary polcy. Under an exernal dran whou conagon he polcy neres rae rses n response o a counry rs premum shoc. he bgger he nernaonal fnancal shoc he hgher he arge neres rae mus rse. However under a double dran wh conagon o domesc fnancal nermedaon he polcy neres rae may eher rse or fall followng an nernaonal rs premum shoc dependng upon he severy of conagon. he more severe he conagon from a global fnancal shoc o a domesc cred crunch he lower he polcy neres rae should be. he reason for hs dfference comes from he naure of he wo ypes of exernal shocs sudden sop and double dran. A hgher domesc neres rae s helpful for mgang he pressure of exchange rae deprecaon and he negave effecs on he cos of mporng nermedae goods under he orgnal sn assumpon. Furhermore an ncrease n lendng neres raes plays a role n reallocang npu resources from he non-raded secor no he raded secor whch s desrable under an exernal dran because raded goods are more valuable o hs economy for repayng foregn deb and expandng ne expors n response o an nernaonal fnancal shoc. Unle he rs premum shoc a domesc cred crunch shoc drecly affecs boh he raded and non-raded secors. Hence he negave mpacs on he raded and non-raded secors are sronger he need o reallocae npu resources no he raded secor h by a secor specfc exernal rs premum shoc weaens and he polcy response o deeroraon of he oupu gap domnaes he movemen of he polcy neres rae under hs double dran case.

31 3 In Fgures 7 and 8 ban loans as well as labor npus o he raded goods secor ncrease wh he hgher domesc neres rae afer a rs premum shoc hs he economy and so he sharp conracon n he raded goods secor can be mgaed. However n he double dran case he non-raded goods secor also faces he hgher pressure of conracon n oupu he moneary auhory s hence requred o suppor he producon acves n boh secors ogeher whch leads o he valdy of lowerng he polcy neres rae. In a double dran case an exernal rs premum shoc has relavely less mpac on he raded good secor because he domesc cred crunch also rases he coss of fnancng common npus used n boh secors. As a resul n a double dran case here s less pressure for he economy o move no a new conraconary equlbrum followng a sudden reversal n capal. able 7. Oupu Responses n wo Secors o a Rs remum Shoc. Exernal Dran Double Dran x x -3 5 x x LD. 5 5 LD LD 5 5 LD Exernal Dran Double Dran Fgure 6. Impulse Responses n he raded and on-raded Secors.

32 32 5. OLUDIG REMARKS Mos emergng economes face he rs of sudden reversals n capal nflows. A sharp surge n he cos of nernaonal borrowng n a foregn currency ends o rgger nsably of he domesc fnancal mares and conracons n real economc acves n hese economes. In hs paper we examne he moneary polcy mplcaons of such an exernal shoc wh focus on s conagon effecs on domesc fnancal nermedaon. Our resuls ndcae ha he moneary auhory should consder o wha exen nernaonal shocs are ransmed o he domesc cred mares when decdes s polcy sance. If here s no conagon and exernal fundng cos shocs are resraned n he raded goods secor an approprae response would be o ncrease he polcy neres rae. However f he ghenng of nernaonal cred condons spreads no he domesc cred mares ha s a double dran occurs moneary easng may be desrable n lne wh he degree of conagon. If he man obecve of he moneary auhory s o preven severe conracons n real economc acves followng exernal fnancal shocs a relavely passve sance s more desrable for an exernal dran whou conagon. In conras under a double dran a more acve moneary polcy sance s requred o mnmze he oupu cos. Our ey resuls are robus o dfferen levels of seady-sae ne foregn asses and me horzons n calculaon of oupu loss. We do no nclude an endogenous mechansm for amplfcaon of nernaonal shocs explcly n he model. he ncluson of any amplfcaon mechansm mgh srenghen he lelhood of a double dran case.

33 33 REFEREES Adran obas and Hyun Shn 28 Lqudy and fnancal cycles BIS Worng apers o 256 Albero Orz ablo O. eres F. Surzenegger and Erneso. eres 27 Moneary and Fscal olces n a Sudden Sop: Is gher Brgher? Mmeo. Bernane B and A. Blnder 988 red money and aggregae demand Amercan Economc Revew vol 78 pp Bernane B. and M. Gerler 989 Agency oss e Worh and Busness Flucuaons Amercan Economc Revew Braggon F. hrsano L.J. and J. Roldos 27 Opmal Moneary olcy n a Sudden Sop BER W alvo G. A. Izquerdo 998 apal Flows and apal-mare rses: he Smple Economcs of Sudden Sops Journal of Appled Economcs ovember pp alvo G. A. Izquerdo and E. alv 26 hoenx Mrales n Emergng Mares: Recoverng whou red from Sysemc Fnancal rses BER Worng aper. o. 2. epedes L. F. R. hang and A. Velasco 24 Balance Shees and Exchange Rae olcy Amercan Economc Revew hrsano L.J. Gus. and J. Roldos 24 Moneary olcy n a Fnancal rss? Journal of Economc heory Vol oo Davd and Mchael B. Devereux 26 Accounng for he Eas Asan rss: A Quanave Model of apal Ouflows n Small Open Economes Journal of Money red and Banng Vol. 38 o. 3. urda V. 27 Moneary olcy Under Sudden Sops Federal Reserve Ban of ew or Saff Repor o Edward Sebasan and arlos A. Vzgh997 Bans and Macroeconomc Dsurbances under redeermned Exchange Raes Journal of Moneary Economcs Echengreen Barryand Rcardo Haussmann 999 Exchange Raes and Fnancal Fragly Federal Reserve Ban of Kansas y. ew hallenges for Moneary olcy pp Eledag Selm and Ivan chaarov 27 Balance Shees Exchange rae olcy and Welfare Journal of economc dynamcs and conrol Gerler M. S. Glchrs and F. M. aalucc 27 Exernal onsrans on Moneary olcy and he Fnancal Acceleraor Journal of Money red and Banng. Heva onsanno 27 Opmal olcy wh Sudden Sops mmeo.

34 34 Huchson Mchael M. and Ilan oy 25 How Bad Are wns? Oupu oss of urrency and Banng rses Journal of Money red and Banng Sudden Sops and he Mexcan Wave: urrency rses apal Flow Reversals and Oupu Loss n Emergng Mares Journal of Developmen Economcs Huchson Mchael M. Ilan oy and Ldan Wang 27 Fscal and Moneary olcy and he os of Sudden Sops Worng aper Kashyap A and J Sen 2 Wha do a Mllon Observaons on Bans Say abou he ransmsson of Moneary olcy? Amercan Economc Revew vol 9 pp Kehoe.J. and K.J. Ruhl 25 Sudden Sops Secoral Reallocaons and he Real Exchange Rae Worng paper. Kollmann R. 22 Moneary olcy Rules n he Open Economy:Effecs on Welfare and Busness ycles Journal of Moneary Economcs Mcallum B.. elson E. 2. Moneary olcy for an Open Economy:an Alernave Framewor wh Opmzng Agens and Scy rces Oxford Revew of Economc olcy Mendoza Enrque G. and Kaherne A. Smh 26 Quanave Implcaons of a Deb-deflaon heory of Sudden Sops and Asse rces Journal of Inernaonal Economcs Mller Vcora 996 Speculave urrency Aacs wh Endogenuously Induced ommercal Ban rses Journal of nernaonal Money and Fnance vol. 5 o he Double Dran wh a ross-border ws: More on he Relaonshp beween Banng and urrency rses he Amercan Economc Revew Vol. 88 o. 2. Orz Albero ablo Oonello F. Surzenegger and E. alv 27 Moneary and Fscal olces n a Sudden Sop : Is gher Brgher?. Van den Heuvel S 22 he Ban apal hannel of Moneary olcy Wharon School Unversy of ennsylvana worng paper Woodford Mchael 23 Ineres and rces: Foundaons of a heory of Moneary olcy rnceon Unversy ress.

35 35 Appendx : Emprcal Impulse Responses from a VAR Model n Korea Response o Generalzed One S.D. Innovaons ± 2 S.E..6 Loan Rae - Depos Rae.6 GD.8 onsumpon Invesmen e Expors/GD.2 Exernal Deb Sample erod : 2./4~28.3/4 Varables : Rs premum Spread beween Loan rae and Depos rae Exernal deb e expors onsumpon Invesmen GD Lag