The Transmsson of us Moneary Polcy Normalzaon o Emergng Markes Absrac Kólver Hernández In hs chaper I analyze he poenal macroeconomc effecs of he normalzaon of US moneary polcy for emergng marke economes (emes) n parcular for Mexco. I buld on he work of Hernandez and Leblebcoğlu (26) by addng moneary elemens o her wo-counry dsge model ha endogenzes mulple ransmsson channels for he ransmsson of nernaonal shocks. Among hose channels are he exchange rae nernaonal bank lendng nernaonal rade and moneary polcy raes. Based on a Bayesan esmaon of he deep parameers of he model I smulae scenaros ha yeld an equlbrum n whch us moneary polcy rae would ncrease n he las wo quarers of 25. The underlyng condons ha promoe he normalzaon of moneary polcy n usa mply favorable growh of around 2.4% n gdp and an average ncrease of 25 bass pons n us polcy rae. For Mexco hose condons carry posve nernaonal spllovers ha resul n an average gdp growh of 2.8%. The ncrease n us rae calls for a response n Mexco s polcy rae n more han one o one.e. calls for an aggressve response. Mexco s polcy rae hke conans he deprecaon of he exchange rae and sablzes nflaon. Keywords: emergng marke busness cycles; ransmsson of foregn shocks; esmaed wo-counry model; nernaonal ransmsson of moneary polcy. el classfcaon: E32 F4. K. Hernández <khernandez@cemla.org> researcher a Research Deparmen Banco de Méxco. The auhor would lke o hank commens from parcpans of he XI Meeng of Moneary Polcy Responsbles a Banco do Brasl and parcpans of he semnar Elaboracón de Proyeccones en Ambenes de Ala Incerdumbre: Experencas desde la Regón a cepal Chle. The vews expressed n hs documen correspond o he auhor and do no necessarly reflec he vews of Banco de Méxco. Addonally hs chaper was elaboraed whle he auhor was member of cemla. 5
. INTRODUCTION Through he lenses of a wo-counry dynamc sochasc general equlbrum (dsge) model hs chaper analyzes mulple underlyng condons ha yeld an equlbrum n whch usa normalzes s moneary polcy by ncreasng he Federal Reserve funds rae. The queson ha I address s: Wha hose condons mply for emergng markes and n parcular for Mexco? I buld on he real busness cycle model developed by Hernandez and Leblebcoğlu (26) o add moneary feaures. The model feaures several channels for he nernaonal ransmsson of shocks among hem: he exchange rae channel nernaonal bank lendng capal flows usa and eme polcy raes and nernaonal rade. As shown frs n Hernandez and Leblebcoğlu (26) hose channels are crucal o capurng he nernaonal ransmsson of shocks. In sharp conras Jusnano and Preson (2) show ha an esmaed sandard small open economy model fals o capure he nernaonal ransmsson of shocks from usa o a small open economy Canada n ha case. In order o dscplne he mulple channels modeled I use 2 me seres from 2Q o 25Q2 for usa and Mexco o esmae he model. The model n-sample predcons are n lne wh he daa. In parcular he model addresses very successfully he Jusnano and Preson (2) crcsm of esmaed dsge models n ha hs model predcs cross-counry correlaons conssen wh he daa. Wh he purpose of produce polcy normalzaon scenaros I use he esmaed model o smulae mllons of pahs for he full economy for he las wo quarers of 25 whch are ou of sample. Then from he smulaed pahs I only consder hose n whch usa neres rae ncreases n one or boh quarers. In he average polcy normalzaon scenaro he model predcs condons n usa ha lead o a polcy rae ncrease of 25 bass pons only wh an average growh of 2.4% n 25. For Mexco hose condons mply a growh of 2.8%. The ncrease n us rae calls for an ncrease n Mexco s polcy rae. Mexco s polcy rae hke conans he ongong deprecaon of he real exchange rae and sablzes nflaon. The res of he chaper s organzed as follows: Secon 2 presens he wo-counry moneary dsge model Secon 3 shows he scenaro analyss and Secon 4 concludes. 6 K. Hernández
2. THE MODEL In hs secon I show he man ngredens of he wo-counry dsge moneary model. The economy feaures domesc (eme) and foregn (us) households wo secors of fnal goods producers (radable and nonradable) n each economy. Followng Chrsano e al. (24) also feaures a capal owner enrepreneurs and a fnancal nermedary addonally has a fscal and a moneary auhores. 2. Households Boh he domesc and foregn households supply labor o he radable and non-radable secors and rade bonds wh he res of he world. The preferences are of he ghh Greenwood e al. (988) ype: U = = ξ β ς + η C ϑ C ϕc L + η ς where C s consumpon L s labor ξ C s a preference shock φ ( ) s a hab parameer η deermnes he Frsch elascy and ϑ s a preference parameer. The compose labor L s a ces baske wh labor n he radable secor L T and labor n he nonradable secor L NT wh he elascy of subsuon χ. The consumpon baske C s defned by a ces aggregaor for he radable consumpon baske C T and he nonradable consumpon baske C NT wh he elascy of subsuon θ. In urn he ces radable consumpon baske s formed by consumpon of he foregn good C F he domesc good C H and a consumpon good ha comes from he res of he world C O. The elascy of subsuon across radable goods s ν. o Households rade rsk-free bonds wh he res of he world B. The budge consran s o ϖ o o 2 * * 2 C + B + B B w L w L 2 o o R B Ω T π ( ) = T T + NT NT + + * * where w T and w NT are he wage raes T denoes lump-sum axes Ω s lump-sum paymens o he households. Bond holdngs are subec o quadrac coss of adusmen ϖ 2 B o o ( B ). The household chooses 2 The Transmsson of us Moneary Polcy Normalzaon 7
o { C L LT LNT B } o maxmze Equaon subec o he budge = consran Equaon 2 he labor and consumpon composes and a no-ponz-game condon. 2.2 Frms There s a connuum of frms wh mass one n each secor. They can be ndexed by z [ ]. Frms are monopolsc compeve and se prces subec o a Calvo prcng scheme.e. frms can change prces only when hey receve a random sgnal ha arrves wh probably ( C) n every perod. In he perods when he producer does no receve he random sgnal aduss he nomnal prce accordng o he ndexaon rule: ι 3 P () z π P () z T NT = ( ) { } where P (z) s he nomnal prce of he varey z n secor π denoes aggregae nflaon and ι [ ] s he ndexaon parameer. The frm z faces a demand of he form P z () 4 Y () z = Y P where λ follows an AR() process specfed below P s he aggregae prce ndex n secor and Y denoes oal demand. 2.2. Technology Frms n he radable secor have he echnology 5 Y ξ u K L λ α α T AT H = ( ) where u s he capal ulzaon rae α ( ) and ξ AT denoes he producvy shock. In he non-radable secor frms face he echnology 6 Y = ξ L NT AN NT where ξ AN denoes he producvy process. I allow for he secoral echnology shocks o be correlaed 8 K. Hernández
( )>. corr ξan ξat Noe ha he correlaon s across secors whn each counry bu here are no cross-counry correlaons among shocks. Frms face a workng capal consran as n Neumeyer and Perr (25) and Urbe and Yue (26). They need o borrow a fracon κ of he payroll coss wh an nra-perod loan. 2.2.2 Prcng Gven he echnology wh consan reurns o scale real profs (n erms of he aggregae consumpon baske) are gven by Π () z p () zy () z mcy () z NT T = { } P z where mc s he margnal cos and p (z) = () where P s he aggregae P prce ndex. Frms recevng he Calvo sgnal o opmally change prces choose p (z) o maxmze = β + Λ + z Λ Π () where β Λ+ s he household s sochasc dscoun facor subec o he Λ demand Equaon 4 and he ndexaon rule Equaon 3. The Appendx A shows ha he prcng scheme yelds he Phllps curves: 7 π = β π + ιπ βιπ + ( )( β ) mc λ βσ λ + nd wh {NT T } where and σ = σ + ιπ nd nd ( ) + π = a π aπ. NT T The Transmsson of us Moneary Polcy Normalzaon 9
2.3 Capal Producer Enrepreneurs and he Fnancal Inermedary Followng Chrsano e al. (24) he capals bulds new raw capal wh he echnology 8 K = δ K ξii 2 ( ) + φi I 2 I and sells o he enrepreneurs where I s nvesmen ξ I s an nvesmen shock and φ I deermnes he convex adusmen cos of nvesmen. The new capal s sold o he enrepreneur a he prce Q k. The enrepreneur receves a producvy shock ω wh ln ( ω) ( σ ω ) ha ransforms he raw capal n effecve capal ωk. The effecve capal s rened o he fnal good producer and afer s used n producon s sold back o he capals. The ( ) k k reurn on capal s ωr k k ur a( u )+ Q δ where R = k and Q k au ( ):= r exp ( σa ( u )) σ gves he ulzaon adusmen cos a ( σ a > ) and δ s he deprecaon rae. The opmal conrac maxmzes he expeced value of he enrepreneur subec o a zero prof condon for he nermedary. The opmaly condons mply: 9 Γ = + [ ] { Γ µ G } Γ R k + + + + k R { Γ+ µ G+ } R+ N N R+ ( L )= L { Γ µ G} R where ω s a hreshold n he producvy shock ha separaes hose ω ha can repay he loan and hose ha defaul F( ω ) df ( ω ) and ω G( ω ) ωdf ( ω ) Γ( ω )= F( ω ) ω + G( ω ) and Γ and G are he correspondng dervaves wh respec oω. 2.4 Fscal and Moneary Polces The governmen purchases goods only from he domesc raded and nonraded secors whch are combned n a compose good smlar o he consumer s consumpon baske. The governmen spendng follows he rule k 2 K. Hernández
Gov Gov Y Y = ( ) ψgy ξ G where ξ G s an exogenous shock and ψ GY s a reacon coeffcen. The moneary auhory follows he Taylor rule: p p R = ρ R + ρ π + ρ Y + r π y mp where ρ r s he smoohng coeffcen and mp s.. d. monearypolcy shock. 3. ESTIMATION AND MONETARY POLICY SCENARIO DESIGN As a general rule I esmae all he parameers ha govern shocks and frcons n he model. I use he Random Walk Meropols-Hasng (rwmh) algorhm as descrbed n An and Schorfhede (27) n parcular o solve he model I use he algorhm dscussed n Hernandez (23) only wh he soluon mehod of Klen (2). I use quarerly daa for Mexco and usa from 2Q o 25Q2. The me seres used are: p Morgan emb + Spread Mexco spread beween baa and -year Treasury for usa shadow federal funds rae for usa he 9-day cees rae for Mexco gdp-deflaor nflaon for Mexco and he usa gdp growh for Mexco and he usa consumpon growh for Mexco and usa nvesmen growh for Mexco and usa blaeral mpors growh for Mexco blaeral expors growh for Mexco gdp-deflaor-based blaeral real exchange rae deprecaon governmen spendng growh for Mexco and usa non-blaeral rade over gdp for Mexco and usa and growh n per capa work hours for usa. 3. The Transmsson Mechansm of us Shocks Fgure shows he mpulse responses of key Mexco s varables o us shocks. Tha s shows he ransmsson mechansms of usa shocks no he Mexcan economy. Frs an expansonary us preference shock ncreases Mexco s gdp nflaon neres raes and deprecaes he peso. The preference shock n usa acs as a usa demand The Transmsson of us Moneary Polcy Normalzaon 2
shock ha ncreases gdp n usa generaes nflaon n usa and as a resul he us moneary polcy has o ncrease he polcy rae. Gven he us rae hke he peso deprecaes whch ogeher wh he larger us demand for Mexcan goods smulaes ne expors n Mexco and hus gdp n Mexco ges smulaed. Tha s he rade channel s of key mporance for he nernaonal ransmsson of hese ypes of shocks. In urn he deprecaon pass-hrough o domesc prces and s nflaonary for Mexco; wh hgher gdp a more deprecaed peso and hgher nflaon he moneary polcy response n Mexco s o ncrease polcy raes o resore he long-erm equlbrum. Second a us echnology shock ncreases us gdp lowers us nflaon and drops he real us neres rae as n any sandard dsge model. In urn he fnancal channel n Mexco akes more relevance for he nernaonal ransmsson of hese ype of shocks because lower nernaonal raes make he us echnology shock o ac as a Mexco echnology shock. Tha s lowers he margnal cos of producon n Mexco as producon fnancng coss are lower. In urn lower margnal coss n Mexco lower nflaon and smulae gdp wh hgher ne expors and as a resul he peso ges apprecaed o help resore he long-erm equlbrum. Fnally a moneary polcy shock n usa s conraconary for usa and lowers us nflaon. An neres rae hke n usa deprecaes he peso whch s passed-hrough o domesc prces n Mexco and nflaon hkes; as a resul he moneary polcy ncreases he polcy rae. The lower us demand for Mexcan goods despe he deprecaed peso drops domesc gdp. Of course hese mpulse responses are ceers parbus exercses amed o undersand he ransmsson mechansms of he model. The acual condons under whch one should expec a hke of us neres raes mus be he end resul of realzaons of varous shocks ha deermne a sae of he us economy ha calls for a less accommodave moneary polcy. The nex subsecon addresses ha ssue. 3.2 Scenaro Analyss The scenaro analyss s conduced as follows. Frs consder he model s soluon and he observables: S = TS + R model s law of moon D = ZS observables 22 K. Hernández
Fgure MEXICO: IMPULSE RESPONSES TO US SHOCKS IN THE ESTIMATED MODEL US PREFERENCE SHOCK.4.35.3.25.2.5..5 GDP 2 3 4.4.3.2. INFLATION 2 3 4 US TECHNOLOGY SHOCK GDP INFLATION.3.2.5...5.2..25 2 3 4 2 3 4 US MONETARY POLICY SHOCK..2.3.4.5 GDP INFLATION.35.3.25.2.5..5 2 3 4 2 3 4 The Transmsson of us Moneary Polcy Normalzaon 23
Fgure (con.) MEXICO: IMPULSE RESPONSES TO US SHOCKS IN THE ESTIMATED MODEL US PREFERENCE SHOCK INTEREST RATE DEPRECIATION..4.8.3.6.2.4..2 2 3 4 2 3 4.2.4.6.8. INTEREST RATE US TECHNOLOGY SHOCK.2...2.3.4.5 DEPRECIATION 2 3 4 2 3 4.4.2..8.6.4.2 INTEREST RATE US MONETARY POLICY SHOCK DEPRECIATION.7.6.5.4.3.2. 2 3 4 2 3 4 24 K. Hernández
where T R and Z are marces formed by funcons of he deep parameers of he model. Use he Kalman fler o oban an esmae of S and D for =... n. Draw f draws of and oban S n + f and D n + f. Repea many mes o oban many possble hsores. Form a loss funcon o wegh all draws of S n + f and D n + f. The weghed average s he forecas. The loss funcon can be very sophscaed for cenral banks. Here I only mpose more wegh o hose draws conssen wh an ncrease of he us neres rae conssen wh he fomc announcemen. Fgure 2 shows he model predcons for he effecs of he normalzaon of us moneary polcy. The model predcs condons n usa ha lead o a polcy rae ncrease of 25 bass pons and average growh of 2.5% n 25. For Mexco hose condons mply a growh of 2.4%. The ncrease n us raes calls for an aggressve response of Mexco s polcy rae. Mexco s polcy rae hke wll conan he ongong deprecaon of he real exchange rae and sablze nflaon. Fgure 2 FORECASTING WITH THE ESTIMATED MODEL GDP US AVG: 2.45 (IMF 2.5) GDP MX AVG: 2.82 (IMF 2.4) 3 2 2 3 6q3 9q q3 2q 3q3 5q 6 4 2 2 4 6 6q3 9q q3 2q 3q3 5q The Transmsson of us Moneary Polcy Normalzaon 25
4. CONCLUSIONS Ths chaper presens a dsge model for he Mexcan economy ha conans mporan channels for he nernaonal ransmsson of us shocks o Mexco. Among he ransmsson channels are: he exchange rae channel nernaonal bank lendng capal flows moneary polcy raes and nernaonal blaeral rade. Based on a Bayesan esmaon of he deep parameers of he model I smulae mllons of scenaros under whch he us moneary polcy rae would ncrease n he las wo (ou of sample) quarers of 25. Those scenaros are bul by drawng sochasc macroeconomc shocks for he whole economy ha s usa Mexco and oher nernaonal shocks are smulaneously consdered. Ou of hose sochasc draws I only consder hose ha yeld an equlbrum n whch he us moneary polcy rae ncreases as a resul. In average hose equlbra are characerzed by favorable gdp growh n boh counres a modes ncrease n he Federal Reserve funds rae and a more han one-oone response n Mexco s polcy rae. The general concluson s ha hose condons ha are needed for he normalzaon of us moneary polcy are good condons for boh usa and Mexco. APPENDIX: PHILLIPS CURVE In hs Appendx I show he deals o oban he Phllps curve of he model. Frs I show how o wre he opmal prce chosen by a frm n a recursve fashon hen I combne ha opmal prce wh he aggregae prce ndex o oban he Phllps curve of he model. A. Opmal Prce Recurson Consder a frm ha can re-opmze s prce n perod he frm chooses P (z) o maxmze we only show he relevan par of profs ha s he case when he frm has o keep he non-opmal prce P + () z =... whch happens wh probably n each fuure perod: βλ+ Π + = βλ PN () z Y () z MC Y = = + + + + + () z 26 K. Hernández
Usng he ndexaon rule (3) profs can be wren as βλ + + = The frs order condon s βλ+ = nd P z + () nd P () z P + MC nd P () z + + P + λ + λ + nd+ ( λ+ ) P z ( () + ) ( ) + Noe ha P P + MC + λ + ( P () z ) λ + nd P P P P 2 P + = = p P P P P + + + + + + + Π s λ + λ + λ + ( Y+ ) ( Y ) + P Y + + ( ) λ +. Y+ ( ). = : = p N s nd + = π π + where I use Π = ( ): =. Dvde he expresson above by P and rewre as a noe ha I mulply by n he erm (λn + ) = ( λn + ) : βλ+ = = λ + λ +. + nd+ ( λ + )( P () z ) p nd λ + nd + βλ + MC + λ + P () z p nd π + ( ) ( ) = π + λ + Y ( ) λ + ( Y + ) +. Lnearzng he expresson above and usng he seady-sae relaon λ mc = we ge λ λ( λ ) Y { P () z MC }+ λy λ + { ( ) { + + () z MC }+ βλy { λ } 2 2 ( ) Y{ + nd+ 2 + P () z MC + 2}+ βλy{ λ + 2} βλ λ Y nd+ P + + 2 2 + βλλ +...} =. The Transmsson of us Moneary Polcy Normalzaon 27
smplfyng and solvng for P N (z) P () z β = MC λ = λ + β nd+ + MC + λ + λ 2 2 + β nd+ 2 + MC + 2 λ + 2 + λ + 3 β 3 nd+ 3 + MC + 3 λ + 3 +... λ noe nd = π + + nd + 2= π + + π + 2 nd + 3= π + + π + 2 + π + 3 hus defne σ = σ + π nd nd + wh σ nd =. Then rewre he prce as P () z β = MC λ = λ + β σ + MC + + 3 3 + β σ + MC nd + λ + λ 2 2 β σnd + MC + 2 λ + 2 λ nd + 2 + 3 + 3 λ λ + +... 28 K. Hernández
or recursvely: P () z = ( β ) MC λ βσnd + β P + () z. λ A.2 Phllps Curve Droppng he ndex z because all frms choose he same prce from he prce ndex: ( ) = ( ) + ( )( ) λ λ λ * P π P P. * In log-lnear and solvng for P + from he prce ndex * P + = P + P + + + P { π }= π + π + usng hs n he opmal prce P * and usng hs back n he prce ndex = ( β ) MC λ βσ nd λ + β π + + P + π P = { P + π }+ ( ) ( β) MC λ βσ λ + β π + + P π + nd or subracng P on boh sdes we oban: π = β π + π β π + ( ) ( β ) mc λ λ + + where mc : = MC P. βσ nd The Transmsson of us Moneary Polcy Normalzaon 29
References An S. and F. Schorfhede (27) Bayesan Analyss of dsge Models Economerc Revews Vol. 26 pp. 3-72. Chrsano L. J. R. Moo and M. Rosagno (24) Rsk Shocks Amercan Economc Revew Vol. 4 pp. 27-65. Greenwood J. Z. Hercovz and G. Huffman (988) Invesmen Capacy Ulzaon and he Real Busness Cycle Amercan Economc Revew Vol. 78 pp. 42-47. Hernández K. (23) A Sysem Reducon Mehod o Effcenly Solve dsge Models Journal of Economc Dynamcs and Conrol Vol. 37 pp. 57-576. Hernández K. and A. Leblebcoğlu (26) The Transmsson of us Shocks o Emergng Markes mmeo. cemla. Jusnano A. and B. Preson (2) Can Srucural Small Open Economy Models Accoun for he Influence of Foregn Dsurbances? Journal of Inernaonal Economcs Vol. 8. Klen P. (2) Usng he Generalzed Schur form o Solve a Mulvarae Lnear Raonal Expecaons Model Journal of Economc Dynamcs and Conrol Vol. 24 pp. 45-423. Neumeyer P. A. and F. Perr (25) Busness Cycles n Emergng Economes Journal of Moneary Economcs Vol. 52 pp. 345-38. Urbe M. and V. Z. Yue (26) Counry Spreads and Emergng Counres: Who Drves Whom? Journal of Inernaonal Economcs Vol. 69 pp. 6-36. 3 K. Hernández