A. The Basic Structure of the Model

12. The model extends a standard sticky-price business cycle framework to include a financial sector and a policy environment characteristic of many emerging market economies in the Central, Eastern, and Southeastern Europe. The structure of the real side of the economy is similar to the DSGE model developed for inflation targeting regimes in Beneš, Castello-Branco, and Vávra (2007). The financial sector block is built drawing mainly on Edwards and Vegh (1997).

13. On the real side, the model includes households and two production sectors: domestic goods and exports. Domestic firms use imports, a (fixed) stock of capital, and labor in producing the domestic goods, differentiate them costlessly and sell them to households as consumption. Domestic firms are monopolistically competitive with each firm having a certain degree of control over its own prices. This allows us to introduce price stickiness and, hence, interactions between real and nominal variables in the medium term. Domestic firms use loans to cover their expenditures and hold deposits in proportion to the required loans. Exports are an exogenous endowment, and are not demanded domestically. Moreover, the terms of trade are exogenous to the country’s exporting industries, suggesting that they are sufficiently small not to have any power over their own price.

14. Households consume domestic goods and supply differentiated labor to production. The labor differentiation is costless and individual household labor types are monopolistically competitive in supplying labor, allowing them to have a degree of control over the wage setting process. Households borrow to finance their consumption and hold deposits in proportion to loans. They also own and internally finance all domestic firms (or receive dividends, for that matter), including financial sector firms, and the central bank.

15. The fully dollarized financial sector has two types of institutions: banks and non-bank financial intermediaries.⁵ The existence of non-bank financial intermediaries is a novel feature of the model, and helps in dealing with the existence of two sources of intermediated funds (i.e., bank loans and direct foreign borrowing) in a tractable way. The roles of banks and non-bank intermediaries are specified as the following:

• Banks collect deposits from households and firms, and extend loans to households and non-bank intermediaries. Banks incur real costs in producing loans and deposits. Consequently, they face upward sloping marginal costs in the loan-to-deposit ratio, resulting in an upward (downward) sloping loan supply (deposit demand) curve, and in endogenous lending and deposit spreads. The net surplus of, or need for, funds is cleared with the world financial market. Banks’ deposits and foreign liabilities are subject to unremunerated reserve requirements set by the monetary authority.

• Nonbank intermediaries are an auxiliary type of agents (in fact, they are part of banks), whose only business is to do a bundling of funds for firms. While households have access only to domestic bank loans, the corporate sector can choose between bank loans and funds obtained directly from abroad. These two sources of funds are, for various reasons, not perfect substitutes, and are, consequently, demanded in a proportion determined by their relative interest costs. Such a mechanism, however, adds to the complexity of the model. To keep it tractable, we do not let firms determine the sources of their financing. Instead, we introduce the nonbank intermediaries to take bank loans and foreign funds and combine them into a bundle with a constant elasticity of substitution.

• When combining the two sources of funds, the nonbank intermediaries seek to minimize the total cost. As the two sources are imperfect substitutes, the demand for each of them becomes downward-sloping in the respective interest rate. The bundle of bank loans and foreign funds is then lent to firms at a rate that is effectively (up to first order) a weighted average of the bank lending rate and the foreign interest rate.

16. Finally, the demand for loans and supply of deposits by households and firms, and the demand for the bundle of funds by the corporate sector are motivated as follows:

• Households cannot directly enter the world financial market or issue or buy bonds: The only saving instrument available to them is bank deposits. On the other hand, they are required to finance their consumption through bank loans. This constraint increases the cost of today’s consumption relative to future consumption, and affects the interest rate channel of monetary transmission, also by introducing a lending-deposit spread.

• Domestic firms are required to obtain funds from nonbank intermediaries (i.e. a bundle of loans from domestic banks and abroad) to finance their working capital (input bill). This constraint increases the marginal cost of production, and hence affects interactions between prices and real economic activity over the business cycle. The firms also hold deposits in proportion to their input bill.

17. The policy environment is characterized by a central bank that uses three types of instruments to conduct monetary policy and influence the economic activity: (i) foreign exchange interventions to manage the nominal exchange rate, (ii) a range of reserve requirements that banks must keep with the central bank, and (iii) controls to limit/regulate the volume (or growth) of bank loans.

B. Description of the Model’s Micro Foundations

18. In this model, households derive their utility from consumption of domestic goods, c_t and disutility from supplying labor, h_t. The one-period utility function is given by

where χ is the degree to which consumption decisions of today are affected by external habit (i.e., the past). Without habit formation, the utility function would imply a unit elasticity of substitution between today’s and tomorrow’s consumption. This is a convenient modeling option. Including habit formation helps reduce the elasticity to more realistic values in the short run, and makes consumption more auto-correlated.

19. Households maximize the expected value of the discounted sum of these one-period utility functions from now to infinity, subject to a budget constraint, balancing their receipts and expenditures over time, and a liquidity constraint. The liquidity constraint requires that the household borrow a certain amount, d_H,t, proportional to consumption expenditures, on top of its long-term debt position, and hold this amount in the form of liquid assets. In this model, low-interest deposits represent such liquid assets. The liquidity constraint is given by:

where d_H,t is the required level of deposits.

20. Domestic producers produce differentiated goods and sell them in monopolistically competitive market to households. Because each firm is facing its own downward-sloping demand curve, we need to distinguish between individual prices and quantities (denoted by lower-case letters and indices i) and market-wide prices and quantities (denoted by upper-case letters). The production function is given by:

Where $q_{t,i}^n$ is firm i’s output, A_t is the level of productivity (common to all producers in the sector), m_t and k_t are imports and capital used in production.

21. Furthermore, each producer faces Rotemberg’s (1982) quadratic costs of price adjustments with backward indexation. The fact that it is costly for firms to deviate from the last period’s market-wide inflation can be viewed as a short-cut for costs associated with frequent price re-optimization, and is the source of nominal rigidities in our model.

22. Similar to the households, each domestic firm must borrow a certain amount, d_F,t, proportional to its working capital (i.e., input factor bill), and hold this amount in the form of liquid assets—low-interest deposits. Formally, the liquidity constraint is given by,

which is a constraint analogous to the one introduced for households. W_t, Z_t and P_M,_t refer to prices of the three input factors: labor, capital, and imports respectively.

23. Banks produce deposits, D_t, and loans, L_t, hold reserves, R_t, with the central bank, get refinancing from the central bank, B_t, and the rest of the world, F_t to maximize profits:

where the balance sheet constraint is L_t + R_t = D_t + B_T + F_t, and the required reserves, $R_t=r_t^d{D}_t+(r_t^d+r_t^f)F_t^b$, apply to both deposits and foreign liabilities, with the two required reserve ratios, $r_t^d$ on deposits and r^f on foreign liabilities, set by the central bank.⁶ Furthermore, i_L,t, i_D,t, and i_B,t are interest rates on loans, deposits, and central bank refinancing respectively, $i_t^{*}$ is the interest rate on foreign funds, and E_t [S_t+1/S_t]is the expected rate of depreciation (or appreciation when negative). The depreciation appears in the profit function because loans, deposits, and foreign funds are denominated in foreign currency whereas reserves are held in domestic currency and the objective of banks is to maximize profits expressed in domestic currency.

24. The profits of banks are affected by costs of producing loans and deposits. The cost function, h (L_t, D_t), is constructed so that the marginal costs (with respect to both loans and deposits) are functions of the ratio L_t/D_t only. This means that the resulting lending and deposit rates will also react to this ratio: the higher L_t/D_t the higher both the lending rate and the deposit rate, and vice versa. Finally, the lending and deposit rates will also be influenced by the setting of the two required reserve ratios, $r_t^r$ and $r_t^m$ by the central bank: (i) an increase in $r_t^r$ will see the lending rate rise with the deposit rate unchanged, whereas (ii) an increase in $r_t^m$ will see both rates rise, and vice versa.

25. The financial intermediaries (formally, part of banks) use a CES technology to combine bank loans and funds borrowed directly from abroad, and lend the bundle of these two types of sources of funds to domestic firms. Again, loans, foreign funds and the bundle are all denominated in foreign currency. The rate intermediaries charge to firms is approximately the weighted average of the bank lending rate and the foreign rate. Since these sources of funds are not perfect substitutes, the demand for each of them is interest cost elastic. The demand functions up to first order can be approximated as:

26. The central bank uses three types of instruments. First it manages the nominal exchange rate of the currency, and sets the two required reserve ratios. Due to foreign exchange interventions, the nominal exchange rate is a process reverting to a central parity,

where, the innovation term, $e_t^s$, is not a forecast error, but rather a tool the central bank uses to manipulate the path for the nominal exchange rate. Because central banks usually tend to do so in response to changing economic conditions, the innovation term can be effectively a function of other macroeconomic indicators.

27. Second, the central bank sets the required reserve ratios, which may also respond to various economic conditions. To simplify the use of the model, we introduce them as autoregressive processes with potentially non-zero unconditional means:

where, r_d and r_f are the unconditional means (steady state). The two innovation terms, $e_t^{\mathit{\text{rd}}}$ and $e_t^{\mathit{\text{rf}}}$ can again be functions of the state of the economy, or used to manipulate the reserve ratios at the central bank’s discretion.

28. Third, the central bank may impose temporary credit volume restrictions on banks, in the form of a maximum period-on-period rate of growth in the total volume of loans granted. To this end, we introduce an additional constraint for banks:

Where ϕ is the growth rate set by the central bank. We assume that one of the above constraints is binding as an equality at all times when the credit controls are in place.⁷ The shadow value of this constraint will, in general, increase the marginal cost of lending, and hence the bank lending rate.

29. The aggregated balance of payments equation describes the change in the country’s net position with the rest of the world as a function of the current account (i.e., the sum of debt service and trade balance). Note that full dollarization entails the dependence of investment income on the actual change in the nominal exchange rate:

where P_X,t X_t − P_M,t M_t is the trade balance, and $(1+i_{t-1}^{*})S_t/S_{t-1}$ is the ex-post investment income rate paid abroad.

30. In solving the model, we proceed as follows: we derive the first-order optimality conditions for the optimization problems of all agents, impose market clearing conditions, and re-write the conditions for the aggregate variables. Then we find the model’s non-stochastic steady state (i.e., a balanced growth path along which all shocks are deterministic zeros), calculate Taylor’s first-order expansion of the optimality conditions around such a steady-state, integrate future expectations out using the Schur generalized decomposition, and find the state-space representation of the model, as described in Klein (2000).⁸

C. Main Characteristics of Policy Transmission

31. The model can be used to analyze the main linkages between the real and financial sectors (Diagram 1). It can then be used to analyze the impact of various domestic and external shocks, as well as to show how the various policy measures affect the rest of the economy. For example, it can help gauge the extent to which policy measures such as reserve requirements or limits on credit by financial intermediaries affect long-run trends and business cycles, helping to assess their monetary and financial sector implications over a medium-term horizon. The model can also be used to analyze the impact of external shocks, such as shocks to foreign prices and interest rates, as well as of a credit crunch triggered by adverse external financial market conditions (see Section IV). Finally, the model can help draw predictions about the implications for business cycle fluctuations (dynamic response-to-shock simulations) and for the changes in the long-run characteristics of the economy (steady-state comparative statics).

Main Macro-Financial Linkages in the Model

Citation: IMF Working Papers 2009, 123; 10.5089/9781451872705.001.A001

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Main Macro-Financial Linkages in the Model

Citation: IMF Working Papers 2009, 123; 10.5089/9781451872705.001.A001

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Main Macro-Financial Linkages in the Model

Citation: IMF Working Papers 2009, 123; 10.5089/9781451872705.001.A001

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32. The working of the main channels of transmission, distinct from a standard sticky-price business cycle framework, can be illustrated with a number of examples:

• Required reserves banks must hold affect the marginal costs of bank lending and deposits, and alter both the optimum levels of lending and deposit rates, and the lending and deposit spreads. Because households and firms must finance part of their expenses by loans, the lending and deposit spreads enter the costs of households’ consumption and firms’ production. The interest rate channel and the cost channel of monetary policy transmission therefore work differently from an economy without such loan constraints and/or required reserves. On the firms’ side, the impact of the policy measures is considerably mitigated because of the existence of an alternative source of funds: foreign direct borrowing. Obviously, the higher the elasticity of substitution between bank loans and direct foreign funds, the smaller effect the monetary policy measures have on the rest of the economy.

• Controls on credit volumes are a binding constraint imposed on the bank lending activities. Hence, they have a non-zero shadow value for banks, raising the marginal cost of bank lending. It is optimal for the banks to pass through the shadow value into the final lending rate. The effectiveness of credit controls is also weaker with the existence of alternative sources of funds. As bank lending rates increase with the shadow value of the credit controls, the bank loans are substituted for direct foreign funds whose cost is not affected. The impact on the total inflow of funds as well as on the effective costs of borrowing is, therefore less pronounced.

• A managed exchange rate regime is to shelter the fully dollarized balance sheets of real economy firms and households from the risks associated with currency mismatch. This is because all revenues and expenses are paid in domestic currency whereas deposits and loans are in foreign currency. The potential effect of large movements in the nominal exchange rate is realized through the aggregated balance of payments equation discussed above.

• Risk-premium-like shocks, which are viewed as one of the main sources of uncertainty in countries under consideration, can be analyzed with the model. The model can experiment with at least three different types of such shocks and can be used to analyze the effect of each shock on the real sector: (i) a shock hitting the cost of foreign funds facing both banks and non-bank borrowers; (ii) a shock hitting the domestic bank lending rate, and (iii) a shock hitting the country’s net position.

A. Parameterizing Steady State

35. When parameterizing the steady state, we proceed in four basic steps. First, we determine the growth, inflation, and interest rate characteristics of the economy. We then use these values, and calibrate the financial block together with the balance of payments. Third, we determine the parameters and other characteristics of the real economy block. Last, we set the model’s two numeraires (the world price level and the central parity) to arbitrary values, and determine the steady-state values for all model variables.

Growth, inflation, and interest rate characteristics

36. In this step, we calibrate the steady-state growth, inflation and interest rate characteristics and related parameters (see Table 1 for a description of these parameters):

• We start with assumptions about the rate of growth of domestic real economic activity, world prices, and world nominal interest rate; based on the observed historical averages, these characteristics directly determine α, π_* and i_*.

• We then proceed as follows: Given an assumption about the long-run domestic lending rate, we can use the Euler equation to obtain the discount factor, β, and the adjusted discount factor, $\tilde{\beta }$. The deposit rate is furthermore linked to the foreign rate through the optimum lending rate equation. We, must hence calibrate the steady state for the two required reserve ratios, r_d and r_f, and choose the long-run ratio of bank loans to deposits, L_ss/D_ss, and the parameter θ_LD, which controls the elasticity of the deposit and lending rates to L/D ratio (see section III.B on parameterizing transitory dynamics).

• With these characteristics pinned down, we can infer about the value of θ_D, the fixed component of the lending spread. Analogously, using the optimum deposit rate equation we obtain the fixed component of the lending spread, θ_L. The two last values should be checked against the elasticity θ_LD to see if they satisfy the general restrictions on cost functions (that is, increasing and convex).

Table 1.

List of Main Behavioral Parameters and Their Baseline Calibration

Table 1.

List of Main Behavioral Parameters and Their Baseline Calibration

Parameter	Description	Baseline value
α	Steady state rate of growth of real economy	1.04¼ – 1
π*	Steady state rate of inflation, world economy	1.02¼ – 1
i*	Steady state nominal rate of interest, world economy	1.04¼ – 1
β	Discount factor	0.96^(1/4)
rd	Steady state required reserve ratio on deposits	0.05
rf	Steady state required reserve ratio on foreign liabilities	0
θD	Fixed component in deposit spread	2.5/400
θL	Fixed component in lending spread	1/400
θLD	Banking cost function parameter	100
v	Determines share of bank loans in bundle borrowed by firms	0.30
Eta	Long-run elasticity of labor supply	0
γM	Import share of gross production	0.34
ò	Elasticity of substitution in monopolistically competitive markets	6
χ	Habit in consumption	0.85
ξW	Wage adjustment costs	1/0.05
ξP	Price adjustment costs	1/0.07
ε	Elasticity of substitution between bank loans and foreign funds	2

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Table 1.

List of Main Behavioral Parameters and Their Baseline Calibration

Parameter	Description	Baseline value
α	Steady state rate of growth of real economy	1.04¼ – 1
π*	Steady state rate of inflation, world economy	1.02¼ – 1
i*	Steady state nominal rate of interest, world economy	1.04¼ – 1
β	Discount factor	0.96^(1/4)
rd	Steady state required reserve ratio on deposits	0.05
rf	Steady state required reserve ratio on foreign liabilities	0
θD	Fixed component in deposit spread	2.5/400
θL	Fixed component in lending spread	1/400
θLD	Banking cost function parameter	100
v	Determines share of bank loans in bundle borrowed by firms	0.30
Eta	Long-run elasticity of labor supply	0
γM	Import share of gross production	0.34
ò	Elasticity of substitution in monopolistically competitive markets	6
χ	Habit in consumption	0.85
ξW	Wage adjustment costs	1/0.05
ξP	Price adjustment costs	1/0.07
ε	Elasticity of substitution between bank loans and foreign funds	2

B. Parameterizing Transitory Dynamics and Stochastic Properties

44. There are seven behavioral parameters that have been introduced to help produce realistic dynamics in the short run: the habit parameter, χ, the two parameters controlling the elasticity of loan demands to real consumption or real costs, λ_h and λ_n, the two price stickiness parameters, ξ_n and ξ_τ, the elasticity of substitution between bank loans and direct foreign funds, η, and the parameter of the bank cost function, θ_LD. These parameters need to be calibrated with respect to the system properties of the model as a whole, such as responses to external, policy, and domestic shocks, or implied autocorrelations (degrees of persistence) as compared to the observed ones. However, we can find some general guidance for setting first-pass values for some of them.

45. The role of the habit parameter is three-fold. First, it reduces the short-run elasticity of substitution in consumption between tradables and domestic (which is unitary in the long run); second, it reduces the short-run elasticity of intertemporal substitution (i.e., the sensitivity of consumption to the real interest rate); third, it entails the dependence of consumption on its own lag. For most countries, realistic values lie between 0.70 and 0.90.

46. The two parameters in loan constraints, λ_h and λ_n, are to increase the elasticity of loans to consumption and funds borrowed from intermediaries to production costs (they both are unitary in the long run). From the two constraints, we can easily see that the elasticities are in both cases 1/(1 − λ). These should be set according to the average magnitude of loan cycles relative to consumption cycles or output cycles.

47. The inverses of the two price stickiness parameters, 1/ξ_n and 1/ξ_τ, multiplied by four (to relate them to annualized inflation) compare well to the stylized parameters on the output gap in models with a New Keynesian Phillips curve or on the pass-through of nominal exchange rate or world price shocks to domestic inflation (the parameter in tradables).

48. The value of the parameter, θ_LD, which controls the elasticity of the deposit and lending rates to L/D ratio, needs to satisfy general conditions for a well-behaved cost function. Besides, because this parameter serves to close the model, we keep its baseline calibration value low, which is the literature standard for parameters with such property. However, this parameter also controls the responsiveness of the banking sector to the credit cycle and the business cycle, in general, and as such is a subject of calibration experiments.

49. The elasticity of substitution between bank loans and direct foreign funds, η, was calibrated to achieve reasonable model properties in terms impulse responses. As a control experiment, in the calibration we used the episode of de facto credit growth controls in 2003 that saw a marked increase in direct foreign borrowing relative to domestic credit extended by banks.

50. In addition to these seven parameters with some behavioral interpretation, we have several other parameters that describe reduced-form autoregressive processes for exogenous and policy variables. The first-pass values can be usually obtained by running simple regressions.

51. Finally, to be able to describe the second moments of the model-induced distributions (which is a useful indicator of the match between the model and the observed data), we need to parameterize the standard errors of the various shocks introduced in the model. We use the following simple procedure. We run a Kalman filter with the same number of shocks as the number of observables (see the list of observables later in this section) with its initial condition treated as deterministic numbers. In such a case, the estimates of unobservables and historical shocks do not depend on the structure of relative standard errors, and we use them to estimate their sample standard errors.

A. Credit Crunch Induced by Exogenous Shocks

59. In this experiment, we examine the effects of the following financial intermediation shocks that are assumed to be triggered by some exogenous factor that affects the ability of banks and the non-bank private sector to borrow from abroad and of banks to lend. The nature of these shocks are similar to the difficulties that have been facing many emerging market economies in the context of the ongoing global financial crisis:

• Type 1 (a “domestic lending shock”) is a shock to banks’ optimal lending rate setting. It corresponds to a situation in which the banks wish to, for whatever reason (e.g., uncertainty about the economic situation or funding conditions, or tightening of lending standards with increased risk aversion), cut back loans to firms and households below the market equilibrium. Banks’ cutting back their loans has a shadow value (forgone profits) associated with it, which increases the marginal cost of bank lending activity, and hence translates into higher lending rates.

• Type 2 (a “country risk premium shock”) is a shock to the rate at which foreign funds are available to the domestic financial intermediation sector (both banking and non-banking). The implied reaction in lending and deposit rates is the result of banks’ optimizing behavior in response to the higher foreign risk premium.¹⁴

• Type 3 (an “interbank shock”) is a shock to the rate at which banks can refinance from the interbank market (i.e., other banks or the central bank). Because the banks are in zero net position with each other under a symmetric equilibrium, this shock describes the effects of a shortage of liquidity provided by the central bank.

60. All three shocks involve a 10 percentage point increase in the relevant interest rate in the first period, gradually brought back to zero at an autoregressive rate of 0.80 (the autoregressive rate is set so that the effect of the shocks dies out in 2-3 years). The impact of the shocks and their transmission channels are summarized in Table 2 and illustrated in Figure 1.

Simulated Effects of the Exogenously Induced Credit Crunch Shock

Citation: IMF Working Papers 2009, 123; 10.5089/9781451872705.001.A001

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Simulated Effects of the Exogenously Induced Credit Crunch Shock

Citation: IMF Working Papers 2009, 123; 10.5089/9781451872705.001.A001

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Table 2.

The Simulated Effects of the Exogenously Induced Credit Supply Shocks

Table 2.

The Simulated Effects of the Exogenously Induced Credit Supply Shocks

	Domestic Lending Shock	Country Risk Premium Shock	Interbank Shock
The shock	10 pp rise in banks’ lending rate	10 pp rise in the rate at which banks and corporates borrow from abroad	10 pp rise in the rate banks refinance from the interbank market
Transmission channel	The shock affects the economy primarily through the intertemporal channel and the cost channel.	The shock affects the economy primarily through the intertemporal channel and income channel.	The shock affects the economy primarily through the intertemporal channel.
On impact	Lending rate goes up Lending-deposit spread goes up, because the deposit rate is unchanged (marginal rate of funding not affected)	Lending rate goes up No change in the lending-deposit spread, because marginal rate of funding also goes up	Lending rate goes up No change in the lending-deposit spread, because marginal rate of funding also goes up
Step 1	Consumption falls because of intertemporal smoothing (higher lending rate). Cost of bank funding goes up, given the higher spread, shifting up the output supply curve, and pushing domestic prices. Though firms partially substitute bank lending for direct foreign borrowing, the cost of borrowing increases. Terms of trade and competitiveness deteriorates as domestic prices rise; exports fall.	Consumption falls because of intertemporal smoothing (higher lending rate), but also because of the need to roll-over foreign debt at higher cost (income channel).	Consumption falls, because of intertemporal smoothing (higher lending rate).
Step 2	Output falls, because of lower exports and consumption. Demand for domestic credit falls, given lower output. Demand for direct foreign borrowing also falls, but less than domestic credit demand Net foreign liabilities fall, as credit demand falls. Inflation goes up, given the higher cost of production	Output falls because of lower consumption. Demand for domestic credit falls given lower output. Demand for direct foreign borrowing falls. Net foreign liabilities increase, because of the higher refinancing costs, and despite falling credit demand. Inflation falls, given the fall in output. Terms of trade and competitiveness improves. Exports rise, partially mitigating the fall in output.	Output falls because of lower consumption Demand for domestic credit falls, given lower output. Demand for direct foreign borrowing falls. Net foreign liabilities fall, as credit demand falls. Inflation falls, given the fall in output. Terms of trade and competitiveness improves. Exports rise, partially mitigating the fall in output.
Step 3	Demand for factor inputs falls. Real/nominal rental rate of capital falls given fixed supply Price of capital falls, given the lower nominal rental rate and higher lending rate (which is used in discounting future rental streams), despite higher domestic price level. Nominal and real wages fall. Employment falls, given the fall in output. The fall in real wages (relative to the cost in other inputs) is not enough to compensate the impact of falling output, given the drop in labor supply (the higher lending-deposit spread reduces the supply of labor since it changes the willingness to work against consumption. Both interest rates affect the household decision making directly – as the cost of borrowing and receipts from holding deposits against consumption rise).	Demand for factor inputs falls. Real/nominal rental rate of capital falls, given fixed supply. Price of capital falls, given the lower nominal rental rate and higher lending rate (discount rate). Nominal and real wages fall. Employment fluctuates around the original level, as the fall in output is compensated by lower wages (which makes labor cheaper relative to imports as another production factor whose price – the exchange rate – does not change.	Demand for factor inputs falls. Real/nominal rental rate of capital falls given fixed supply Price of capital falls, given the lower nominal rental rate and higher lending rate (discount rate). Nominal and real wages fall. Employment fluctuates around the original level, as the fall in output is being compensated by lower wages (which makes labor cheaper relative to imports as another production factor whose price – the exchange rate – does not change).

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Table 2.

The Simulated Effects of the Exogenously Induced Credit Supply Shocks

	Domestic Lending Shock	Country Risk Premium Shock	Interbank Shock
The shock	10 pp rise in banks’ lending rate	10 pp rise in the rate at which banks and corporates borrow from abroad	10 pp rise in the rate banks refinance from the interbank market
Transmission channel	The shock affects the economy primarily through the intertemporal channel and the cost channel.	The shock affects the economy primarily through the intertemporal channel and income channel.	The shock affects the economy primarily through the intertemporal channel.
On impact	Lending rate goes up Lending-deposit spread goes up, because the deposit rate is unchanged (marginal rate of funding not affected)	Lending rate goes up No change in the lending-deposit spread, because marginal rate of funding also goes up	Lending rate goes up No change in the lending-deposit spread, because marginal rate of funding also goes up
Step 1	Consumption falls because of intertemporal smoothing (higher lending rate). Cost of bank funding goes up, given the higher spread, shifting up the output supply curve, and pushing domestic prices. Though firms partially substitute bank lending for direct foreign borrowing, the cost of borrowing increases. Terms of trade and competitiveness deteriorates as domestic prices rise; exports fall.	Consumption falls because of intertemporal smoothing (higher lending rate), but also because of the need to roll-over foreign debt at higher cost (income channel).	Consumption falls, because of intertemporal smoothing (higher lending rate).
Step 2	Output falls, because of lower exports and consumption. Demand for domestic credit falls, given lower output. Demand for direct foreign borrowing also falls, but less than domestic credit demand Net foreign liabilities fall, as credit demand falls. Inflation goes up, given the higher cost of production	Output falls because of lower consumption. Demand for domestic credit falls given lower output. Demand for direct foreign borrowing falls. Net foreign liabilities increase, because of the higher refinancing costs, and despite falling credit demand. Inflation falls, given the fall in output. Terms of trade and competitiveness improves. Exports rise, partially mitigating the fall in output.	Output falls because of lower consumption Demand for domestic credit falls, given lower output. Demand for direct foreign borrowing falls. Net foreign liabilities fall, as credit demand falls. Inflation falls, given the fall in output. Terms of trade and competitiveness improves. Exports rise, partially mitigating the fall in output.
Step 3	Demand for factor inputs falls. Real/nominal rental rate of capital falls given fixed supply Price of capital falls, given the lower nominal rental rate and higher lending rate (which is used in discounting future rental streams), despite higher domestic price level. Nominal and real wages fall. Employment falls, given the fall in output. The fall in real wages (relative to the cost in other inputs) is not enough to compensate the impact of falling output, given the drop in labor supply (the higher lending-deposit spread reduces the supply of labor since it changes the willingness to work against consumption. Both interest rates affect the household decision making directly – as the cost of borrowing and receipts from holding deposits against consumption rise).	Demand for factor inputs falls. Real/nominal rental rate of capital falls, given fixed supply. Price of capital falls, given the lower nominal rental rate and higher lending rate (discount rate). Nominal and real wages fall. Employment fluctuates around the original level, as the fall in output is compensated by lower wages (which makes labor cheaper relative to imports as another production factor whose price – the exchange rate – does not change.	Demand for factor inputs falls. Real/nominal rental rate of capital falls given fixed supply Price of capital falls, given the lower nominal rental rate and higher lending rate (discount rate). Nominal and real wages fall. Employment fluctuates around the original level, as the fall in output is being compensated by lower wages (which makes labor cheaper relative to imports as another production factor whose price – the exchange rate – does not change).

61. The three credit crunch shocks affect the real and financial sectors of the model economy through different channels of transmission:

• The intertemporal channel is present in all three simulations. Because the lending rates increase, it is optimal for households to cut back their consumption today, and hence reduce aggregate demand. This is the most traditional channel of monetary policy transmission. The intertemporal channel has also other attributes of a demand-side shock: a drop in output leads to a drop in prices and inflation.

• The cost channel is quantitatively important only in type 1 simulation (the “domestic lending shock”), since it works through the lending-deposit spread. The higher the spread, the costlier it is for households and firms to hold liquid assets (low-interest deposits or money) for their transactions. An increase in the spread therefore adds to the effective price of consumption facing households, and to the nominal marginal cost of production facing firms. As a result, this channel resembles a supply-side shock: prices and inflation rise, whereas economic activity falls. The domestic lending shock is the only one that pushes inflation above its long run level in a period of an output downturn.

• The income channel is linked to the rate the country must repay its debt, and is only present in type 2 simulation (the “country risk premium shock”). A higher rate produces a large deterioration in real consumption demand and in the net investment position (relative to type 1 and type 3 simulations).

62. The impact of the three shocks on real activity depends also on the response of exports. Because the rest of the world’s demand for domestic exports is assumed to be price-elastic, whether the domestic cost of production increases or decreases after the financial shock matters for the response of exports (i.e., whether the demand or supply-side channel prevails). This is best seen comparing type 1 (the “domestic lending shock”) and type 2 (the “country foreign risk premium”) simulations: the supply-side shock nature of the domestic lending shock makes production more expensive, pushing export prices up and leading to a reduction in the world demand for domestic goods. This drop in exports deteriorates domestic economic conditions further. On the other hand, the country risk premium and interbank shocks reduce domestic prices, stimulating exports.

63. On the financial sector side, the volume of credit falls in all three simulations (ranging from approximately 5 to 10 percent). The credit supply curve, which is calibrated to be relatively flat, shifts upward in all three simulations, making bank loans more expensive. While financial intermediaries partially substitute bank loans with direct borrowing (except in type 2 shock where there is no room for substitution, because the costs of both funding sources increase by the same amount), the overall cost of credit increases. The demand for credit also falls through other channels: first, the response of real consumption (through the intertemporal and income channels in the first round) determines the volume of real consumer credit demand; second, real consumption together with real exports (mainly through the cost channel) determine the overall change in output, and hence firms’ real credit demand for working capital; and third, the movement in domestic prices translates the changes in real credit into nominal credit.

64. The credit crunch simulations clearly highlight the linkages between the real and financial sectors of the economy. All three financial shocks have significant real sector implications, generating much lower consumption, output, employment, and prices of factor inputs. The size of the impact is larger in the foreign risk premium and lending shock scenarios, compared with the interbank shock. The large decline in output under the risk premium shock reflects the sharp fall in consumption (given the intertemporal smoothing by consumers and the need to roll over foreign debt at a higher cost), and despite the rise in exports that partially mitigates the fall in output. Under the domestic lending shock, the output fall reflects both the significant drop in consumption and the initial fall in exports as the rise in domestic prices leads to a deterioration in the terms of trade. In the interbank shock scenario, the decline in output is smaller given the more moderate drop in consumption and the rise in exports that partly mitigates the output fall. Inflation also falls, reflecting the lower economic activity. The impact on inflation of the domestic lending shock is small, given the rise in the cost of production (as in a supply shock).

65. Activity in the domestic financial sector is also reduced following the shocks. Under all three scenarios, the negative shock to credit supply initially generates (i) higher bank lending rates; (ii) lower demand for bank credit as loans become more expensive and output and consumption fall; (iii) lower foreign borrowing by banks (due to lower demand for bank loans—under all three shocks, and/or to more expensive external funds—under the foreign risk premium shock); and (iv) lower direct borrowing by corporations (either due to lower production—under all three scenarios, and/or higher cost of borrowing from abroad—under the foreign risk premium shock). The fall in bank credit is bigger under the foreign risk premium shock (followed by the domestic lending shock), given the larger drop in output and consumption, compared with the interbank shock. NFLs of firms and banks rise (and the current account deteriorates) under the risk premium shock (while the opposite happens under the other two scenarios) because of the higher refinancing costs, and despite lower foreign borrowing by the financial intermediation sector and the lower credit demand.

66. As the credit crunch fades away following the first year, economic activity (and prices) overshoots before stabilizing at pre-shock levels, with corresponding movements in other nominal and real variables. This overshooting generates additional economic oscillations lasting two to three years before the economy stabilizes. The oscillations are most pronounced in the case of the foreign risk premium shock, because the limited scope of the corporates to substitute loans from the banking sector with direct foreign borrowing results in a sharper contraction in production. When the shock disappears, bank lending and interest rates return to their pre-shock levels. It takes longer for net foreign liabilities to return to their pre-shock levels partly because it takes time for domestic prices relative to foreign prices (terms of trade) to reach their steady state level; the risk premium that changes interest rates in response to the deviation of NFL from its steady state level also adjusts very slowly.

B. Policy Induced Credit Crunch

Price-based Controls on Bank Credit

67. In this experiment, we examine the effects of two policy measures aimed at reducing the growth of bank loans to the private sector by making costly, and hence reducing, the funding sources of credit: (i) an increase in reserve requirement (RR) on domestic deposits; and (ii) an increase in RR on banks’ foreign borrowing. We also look at the implications of potential circumvention of the second measure, by allowing for the possibility of direct foreign borrowing by firms; the latter is normally outside the control of the monetary authority, and is, therefore, not normally subject to reserve requirements, thereby creating scope for firms to get around the measures affecting banks.¹⁵ To compare it with the case of no circumvention, we remove the direct foreign borrowing channel by assuming that the RR can also be enforced on firm’s direct borrowing, hence letting the cost of the two types of foreign funds be affected identically.

68. The objective of these experiments is to analyze the real and financial sector implications of these price based measures aimed at affecting bank credit. In all three simulations, the RRs are raised by 10 percentage points in the first period, and are gradually brought back at an autoregressive rate of 0.95 (the autoregressive rate is set so that the effect of the shock dies out in 4-5 years, reflecting the fact that when such measures are imposed, agents treat them more or less as permanent, and set expectations accordingly. The impact of these shocks and their transmission channels are provided in Table 3 and Figure 2.

Simulated Effects of the Price-Based Credit Measures

Citation: IMF Working Papers 2009, 123; 10.5089/9781451872705.001.A001

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Simulated Effects of the Price-Based Credit Measures

Citation: IMF Working Papers 2009, 123; 10.5089/9781451872705.001.A001

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Simulated Effects of the Price-Based Credit Measures

Citation: IMF Working Papers 2009, 123; 10.5089/9781451872705.001.A001

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Table 3.

The Simulated Effects of the Policy Shocks to Credit Supply: Price-based Credit Measures

Table 3.

The Simulated Effects of the Policy Shocks to Credit Supply: Price-based Credit Measures

	Higher reserve requirement on deposits	Higher reserve requirement on foreign borrowing (no circumvention)
Shock	The shock raises the RR by [10] percentage points in the first period, gradually bringing it back at an autoregressive rate of 0.95.	The shock raises the RR by [10] percentage points in the first period, gradually bringing it back at an autoregressive rate of 0.95.
Transmission channel	The shock affects the economy primarily through the cost channel, resembling a supply side shock. It causes a decrease in the deposit rate, and hence a higher lending-deposit spread.	The shock affects the economy mainly through the intertemporal substitution channel. It leads to an increase in the bank lending rate, as well as in the deposit rate (since marginal costs of all bank activities rise), hence with little change in lending-deposit spread.
On impact	The deposit rates fall, while lending rates remain unchanged. This is because the marginal rate of funding from abroad remains unchanged, and hence the rates banks pay to depositors need to fall to compensate for the higher RR.	The marginal cost of borrowing from abroad for banks increase, making loans to the private sector more expensive (higher lending rate). It also drives up deposit rates by approximately the same amount, leaving the lending-deposit spread little changed.
Step 1	The higher lending-deposit spread makes debt financing of firms more expensive, pushing up their supply curve, and raising prices.	Higher lending rates bring consumption down (intertemporal substitution of consumption today for consumption tomorrow). Demand for consumer loans also falls.
Step 2	Higher prices of domestic goods then lead to substitution away from domestic goods, leading to a fall in net exports, hence lower output, and lower consumption given falling export revenues. Bank credit and direct borrowing decline given lower output and consumption. Wages increase, matching inflation, while the real wage remains about unchanged.	Output falls, with falling consumption. Falling output brings down inflation.
Step 3	The real rate of capital rental (as the price of capital flow) falls with falling output: with the supply of capital fixed, falling production and demand for capital translates into a lower real rental rate. Nominal rental rates fall too, although most of the fall in the real rental rate comes through higher inflation of domestic goods. The nominal price of capital (as an asset) increases: Although the nominal rental rate is lower throughout the simulation, the higher general price level in the economy also drives up the price of capital in the future (so that ultimately, the relative price of production and capital are unchanged). The higher expected price of capital in the future also translates to higher price today, offsetting the effect of lower rental rates. Employment declines proportionately more than the fall in production, because: (i) lower output lowers labor demand, and (ii) the price of labor (whose real wages are unchanged) increases relative to that of imports (nominal exchange rate constant incontrast to falling nominal wages) and capital (real price of capital falls), so the demand for labor declines more than the demand for imports and capital.	Net exports increase on account of improved terms of trade (lower domestic prices). Higher exports partially mitigate the effect of falling consumption on output, so output declines less than consumption. Falling output and consumption bring down demand for bank credit. With lower credit, net foreign borrowing also declines. Subsequently, nominal and real wages fall in line with falling demand for labor Employment falls, but proportionately less then output, because real wages fall relative to the price of imports (nominal exchange rate constant), thus mitigating the effect of falling output on employment. Nominal rental rate of capital falls more than the rate of inflation, so that the real rental rate falls. Falling output shifts down the demand for capital curve, which (with a fixed capital supply) translates to a falling real rental rate. Price of capital (as an asset) declines owing both the fall in the nominal rental price as well as the decline in the general price level that pushes down the final price of assets.
Step 4 (long run)	Falling output over time brings inflation down, offsetting the effect of higher lending-deposit spread that gradually vanish. This triggers substitution back to domestic goods, leading to a gradual recovery of output, consumption and credit. Higher price of capital translates into a lower country risk premium that contributes to a faster decline in lending-deposit spread.	Falling domestic prices over-time bring more demand to domestic production. Output and credit recover, and labor even temporarily increases above the initial level thanks to the relatively low real wages (compared to real exchange rate). Through the cost channel, prices go up, eroding the competitive advantage.

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Table 3.

The Simulated Effects of the Policy Shocks to Credit Supply: Price-based Credit Measures

	Higher reserve requirement on deposits	Higher reserve requirement on foreign borrowing (no circumvention)
Shock	The shock raises the RR by [10] percentage points in the first period, gradually bringing it back at an autoregressive rate of 0.95.	The shock raises the RR by [10] percentage points in the first period, gradually bringing it back at an autoregressive rate of 0.95.
Transmission channel	The shock affects the economy primarily through the cost channel, resembling a supply side shock. It causes a decrease in the deposit rate, and hence a higher lending-deposit spread.	The shock affects the economy mainly through the intertemporal substitution channel. It leads to an increase in the bank lending rate, as well as in the deposit rate (since marginal costs of all bank activities rise), hence with little change in lending-deposit spread.
On impact	The deposit rates fall, while lending rates remain unchanged. This is because the marginal rate of funding from abroad remains unchanged, and hence the rates banks pay to depositors need to fall to compensate for the higher RR.	The marginal cost of borrowing from abroad for banks increase, making loans to the private sector more expensive (higher lending rate). It also drives up deposit rates by approximately the same amount, leaving the lending-deposit spread little changed.
Step 1	The higher lending-deposit spread makes debt financing of firms more expensive, pushing up their supply curve, and raising prices.	Higher lending rates bring consumption down (intertemporal substitution of consumption today for consumption tomorrow). Demand for consumer loans also falls.
Step 2	Higher prices of domestic goods then lead to substitution away from domestic goods, leading to a fall in net exports, hence lower output, and lower consumption given falling export revenues. Bank credit and direct borrowing decline given lower output and consumption. Wages increase, matching inflation, while the real wage remains about unchanged.	Output falls, with falling consumption. Falling output brings down inflation.
Step 3	The real rate of capital rental (as the price of capital flow) falls with falling output: with the supply of capital fixed, falling production and demand for capital translates into a lower real rental rate. Nominal rental rates fall too, although most of the fall in the real rental rate comes through higher inflation of domestic goods. The nominal price of capital (as an asset) increases: Although the nominal rental rate is lower throughout the simulation, the higher general price level in the economy also drives up the price of capital in the future (so that ultimately, the relative price of production and capital are unchanged). The higher expected price of capital in the future also translates to higher price today, offsetting the effect of lower rental rates. Employment declines proportionately more than the fall in production, because: (i) lower output lowers labor demand, and (ii) the price of labor (whose real wages are unchanged) increases relative to that of imports (nominal exchange rate constant incontrast to falling nominal wages) and capital (real price of capital falls), so the demand for labor declines more than the demand for imports and capital.	Net exports increase on account of improved terms of trade (lower domestic prices). Higher exports partially mitigate the effect of falling consumption on output, so output declines less than consumption. Falling output and consumption bring down demand for bank credit. With lower credit, net foreign borrowing also declines. Subsequently, nominal and real wages fall in line with falling demand for labor Employment falls, but proportionately less then output, because real wages fall relative to the price of imports (nominal exchange rate constant), thus mitigating the effect of falling output on employment. Nominal rental rate of capital falls more than the rate of inflation, so that the real rental rate falls. Falling output shifts down the demand for capital curve, which (with a fixed capital supply) translates to a falling real rental rate. Price of capital (as an asset) declines owing both the fall in the nominal rental price as well as the decline in the general price level that pushes down the final price of assets.
Step 4 (long run)	Falling output over time brings inflation down, offsetting the effect of higher lending-deposit spread that gradually vanish. This triggers substitution back to domestic goods, leading to a gradual recovery of output, consumption and credit. Higher price of capital translates into a lower country risk premium that contributes to a faster decline in lending-deposit spread.	Falling domestic prices over-time bring more demand to domestic production. Output and credit recover, and labor even temporarily increases above the initial level thanks to the relatively low real wages (compared to real exchange rate). Through the cost channel, prices go up, eroding the competitive advantage.

69. The simulations illustrate that the way the RRs on deposits and foreign borrowing influence real economic activity depends on the implications of the two policy measures for the behavior of lending and deposit rates. The two instruments have similar qualitative effects on output, consumption, and employment, but differing consequences for domestic prices, exports, and the current account balance, reflecting how the changes in the two instruments are transmitted to the economy. The shock to the RR on deposits affects the economy primarily through the cost channel, resembling a supply side shock. The shock to the RR on foreign borrowing affects the economy mainly through the intertemporal substitution channel:

• RRs on deposits push the deposit rate down, without first-round effects on the lending rate, since the marginal rate at which extra funds are available is still given by the unchanged foreign interest rate. As a result, the lending-deposit spread rises, making it costly to hold liquidity for private agents (households for consumption purchases and firms for payment of the input factor bill). This direct policy instrument hence works primarily through the cost channel, similar to a supply-side shock.

• RRs on foreign borrowing, on the other hand, increase the marginal refinancing cost of the banking sector. Both the lending and deposit rates go up in response, with very little effect on the spread, implying that real activity goes down mainly through the intertemporal substitution channel.

70. All simulations see a drop in output and employment. In the case of RRs on deposits, the output fall is driven mainly by exports, whereas in the case of RRs on foreign borrowing, domestic demand matters more. Higher deposit RRs work as a supply-side shock, thereby resulting in lower output and higher prices. Domestic aggregate demand, on the other hand, initially does not change much (with little change in lending rates); lower output is therefore due mainly to lower exports, with domestic goods now more expensive. In contrast, the higher RR on foreign borrowing reduces aggregate demand (and output) through higher lending rates. The demand for domestic exports increases given the lower domestic prices, thus mitigating the extent of the overall output decline. Lower output results in a fall in bank credit as a result in all scenarios, as well as a decline in net total foreign borrowing. The size of the responses of model variables is much larger for the shock to RR on foreign borrowing.

71. Overall, the shock to RRs on foreign borrowing affect the real economy through a similar propagation mechanism, and has similar effects on the real and financial sector variables, whether or not the measure can be circumvented through the possibility of direct borrowing by the corporate sector. One important exception is the behavior of direct foreign borrowing by corporations; the latter increases under the circumvention scenario, despite the fall in total demand for credit, because the effect of the cheaper relative cost of borrowing directly from abroad, compared to borrowing from the domestic banking system, dominates. Moreover:

• The quantitative impact of the shock on model variables is smaller when the private sector can bypass the RR on banks by directly borrowing from abroad at an unchanged cost, thereby substituting partially the banking sector credit that becomes more expensive with the higher RR. The circumvention is not full, because the two types of loans are not perfect substitutes. Despite the substitution, the overall cost of credit for domestic firms increase (higher effective lending/borrowing rate in Figure 2), resulting in a contraction in output of the domestic sector, and a fall in consumption, employment, and total credit to the private sector. The effective lending rate facing the real sector is even higher when we shut down the alternative borrowing channel. The fall in employment, consumption and output is hence much larger when corporates cannot substitute the more expensive bank loans with loans from abroad.

• When firms can circumvent through direct foreign borrowing, the effect on total net liabilities is also smaller, as the decline in banks’ foreign borrowing from abroad is largely offset by the increase in firms’ foreign direct borrowing at an unchanged interest rate. If the two types of funds were perfect substitutes, firms would simply stop borrowing from the banking sector, and replace these funds with direct loans from abroad. The effective lending rate would hence not be affected by the policy measure, with no implications for real economic activity.

72. The policy simulations analyzed here illustrate that measures to affect bank credit can have significant effects on the real sector of our stylized economy. The overall effect of the measures would depend, however, on the type of controls imposed, as well as the private sector’s ability to get around the measures by substituting the targeted credit with alternative sources of funding. The impact of the measures on the targeted macro aggregates (such as, total credit to the private sector—provided both by domestic banks and from abroad—and total foreign liabilities of the economy) could therefore be much weaker than desired.

Credit growth controls

73. In this experiment, we examine the impact of imposing limits on the growth rates of credit extended by banks. The limits are for a period of one year, and are abandoned subsequently. The set-up of the credit controls is known to, and anticipated by, all private agents. Banks are required to extend credit at a rate 4 percentage points lower than in “normal” times (i.e. in the long-run or, strictly speaking, in the steady-state) for four consecutive quarters.

74. The credit controls are introduced as a quantitative restriction to an individual bank’s optimization problem, and give rise to a shadow value affecting the lending rate. Because the controls are imposed on the growth rate, and not on the level, of credit, today’s lending rate setting is determined not only by today’s, but also tomorrow’s expected shadow value of the restriction. The information set-up of the exercise (i.e. how long the controls are announced to last, how long they are expected, and how long they actually last) is therefore important for the outcomes. The main transmission channels of the policy shock and its impact on the real and financial sectors of the economy are summarized in Table 4 and illustrated in Figure 3.

Simulated Effects of the Direct Credit Controls

Citation: IMF Working Papers 2009, 123; 10.5089/9781451872705.001.A001

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Simulated Effects of the Direct Credit Controls

Citation: IMF Working Papers 2009, 123; 10.5089/9781451872705.001.A001

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Simulated Effects of the Direct Credit Controls

Citation: IMF Working Papers 2009, 123; 10.5089/9781451872705.001.A001

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Table 4.

The Simulated Effects of the Individual Policy Shocks to Credit

Supply: Credit Growth Controls

Table 4.

The Simulated Effects of the Individual Policy Shocks to Credit

Supply: Credit Growth Controls

The shock	A limit is imposed on the growth rate of credit extended by the banks. The limits are maintained for the period of one year, and abandoned afterwards. The shock is equivalent to imposing an extra constraint on banks’ optimization: $L_t\le \overline{L}\cdot$.
Transmission channel	The credit control affects the economy through two main channels: drop in consumption (intertemporal channel) and exports (more expensive production worsening the competitiveness).
On impact	Credit to households and firms decline in line with the imposed credit growth controls. The lending rate increases, reflecting the rise in the shadow value of the credit constraint, since credit controls are costly for banks. The bank lending-deposit spread goes up, since deposit rates are not affected on impact, because the marginal rate of foreign borrowing is unchanged. Bank foreign liabilities fall, as the need for external borrowing to support credit growth declines.
Step 1	Consumption falls, following the rise in the lending rate. Firms replace partially the more expensive bank credit for cheaper direct foreign borrowing as the cost of bank credit goes up, but the overall cost of credit to firms rises (and overall credit, both from domestic banks and from abroad, decline – see step 2). Inflation falls, as the fall in demand (consumption) offsets the higher production costs (supply curve shifts up with higher lending-deposit spread). Terms of trade improve, as the domestic prices falls.
Step 2	Exports increase, as competitiveness (terms of trade) improve. Output falls because of falling consumption. Direct foreign borrowing also falls, as the output falls, although less than bank credit Overall, total foreign borrowing (by banks and firms) is lower because less credit extension by banks and lower output by firms require less borrowing from abroad.
Step 3	Real and nominal returns to capital decline. With output down, the demand for capital declines, which (given the fixed supply of capital) translates into falling real rental rate. Nominal rates of return fall too, as the rise in inflation does not bring real rates down sufficiently. Price of capital (as an asset) declines, following the decline in nominal rental rates and higher lending rates. After a temporary drop, nominal wages rise to match higher inflation so that real wages are about unchanged. Employment drops, as labor demand falls and the real wage rate does not adjust. The decline in labor is more pronounced given the higher price of labor relative to foreign inputs (nominal exchange rate unchanged),
Step 4 (Long-run effects)	There is a sharp reversal, after the growth controls are removed, with some oscillations before the economy reverts to its steady state. The falling output brings inflation down. Lower inflation subsequently improves terms of trade, exports, and output. The interest rates adjust immediately after the controls are removed, and credit recovers, going back to its steady state after three years.

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Table 4.

The Simulated Effects of the Individual Policy Shocks to Credit

Supply: Credit Growth Controls

The shock	A limit is imposed on the growth rate of credit extended by the banks. The limits are maintained for the period of one year, and abandoned afterwards. The shock is equivalent to imposing an extra constraint on banks’ optimization: $L_t\le \overline{L}\cdot$.
Transmission channel	The credit control affects the economy through two main channels: drop in consumption (intertemporal channel) and exports (more expensive production worsening the competitiveness).
On impact	Credit to households and firms decline in line with the imposed credit growth controls. The lending rate increases, reflecting the rise in the shadow value of the credit constraint, since credit controls are costly for banks. The bank lending-deposit spread goes up, since deposit rates are not affected on impact, because the marginal rate of foreign borrowing is unchanged. Bank foreign liabilities fall, as the need for external borrowing to support credit growth declines.
Step 1	Consumption falls, following the rise in the lending rate. Firms replace partially the more expensive bank credit for cheaper direct foreign borrowing as the cost of bank credit goes up, but the overall cost of credit to firms rises (and overall credit, both from domestic banks and from abroad, decline – see step 2). Inflation falls, as the fall in demand (consumption) offsets the higher production costs (supply curve shifts up with higher lending-deposit spread). Terms of trade improve, as the domestic prices falls.
Step 2	Exports increase, as competitiveness (terms of trade) improve. Output falls because of falling consumption. Direct foreign borrowing also falls, as the output falls, although less than bank credit Overall, total foreign borrowing (by banks and firms) is lower because less credit extension by banks and lower output by firms require less borrowing from abroad.
Step 3	Real and nominal returns to capital decline. With output down, the demand for capital declines, which (given the fixed supply of capital) translates into falling real rental rate. Nominal rates of return fall too, as the rise in inflation does not bring real rates down sufficiently. Price of capital (as an asset) declines, following the decline in nominal rental rates and higher lending rates. After a temporary drop, nominal wages rise to match higher inflation so that real wages are about unchanged. Employment drops, as labor demand falls and the real wage rate does not adjust. The decline in labor is more pronounced given the higher price of labor relative to foreign inputs (nominal exchange rate unchanged),
Step 4 (Long-run effects)	There is a sharp reversal, after the growth controls are removed, with some oscillations before the economy reverts to its steady state. The falling output brings inflation down. Lower inflation subsequently improves terms of trade, exports, and output. The interest rates adjust immediately after the controls are removed, and credit recovers, going back to its steady state after three years.

75. The impact of the credit limit on the real economy is similar qualitatively to those of the increase in reserve requirements on foreign borrowing. Real economic activity, consumption, and employment fall as bank credit to the private sector is constrained by the monetary authority, with the shock transmitted to the economy through an increase in banks’ lending rate that leads to a higher lending-deposit rate spread (hence making output and consumption more costly). The fall in inflation leads to an increase in exports and an improvement in the current account. Total borrowing from abroad goes down as bank credit and economic activity falls.

76. Similar to the earlier experiment, the magnitude of the shock impact on the financial and real variables of the model is more subdued when the corporate sector can partially substitute bank credit with direct borrowing from abroad (i.e., with circumvention of the bank credit limits imposed on domestic banks). After the credit growth controls are removed, the economy reverts to its steady state following some oscillations in the model variables. With the falling output bringing inflation down, terms of trade, and consequently exports, improve, finally pushing output up as well. The interest rates adjust immediately after the controls are removed, and credit to the private sector recovers back to its steady state.