Appendix A - Optimal Contracting Problem
Entrepreneurs observe ωt+1(k) ex post, but the lenders can only observe it at a monitoring cost which is assumed to be a certain fraction (μ) of the return. As shown by Bernanke et al. (1999), the optimal contract between the lender and the entrepreneur is a standard debt contract characterized by a default threshold,
We assume that each entrepreneur is subject to an idiosyncratic shock ωt ∊ [0, ∞) with E(ωt) = 1 and c.d.f and p.d.f are given by F(ωt) and f(ωt). We define
Recall that the misperception of investors regarding the distribution of ωt+1 is represented by ϱt such that
We also define
Noting that the monitoring cost (υt) is given by
which can be re-arranged to yield:
We assume that the aggregate risk in terms of the exchange rate and the return to capital is borne by lenders such that the participation constraint holds with expectations as in Cespedes et al. (2004), Elekdag and Tchakarov (2007) and Curdia (2008). Therefore, it should be clear that return to capital (RK) and the cut off value
We can now analyze the optimal contract which determines a state contingent cut off value
subject to the participation constraint (A8). The optimality conditions for this maximization problem are:
where U is the state of the world, π(U) is the probability of the state U and Λt+1 is the Lagrangian multiplier. Substituting (A12) into (A11) yields:
Given that entrepreneurs are identical ex ante, each entrepreneur faces the same financial contract. We can then write the external risk premium (1+Φt+1) as follows:
Using (A14), (A13) can be re-written as
Appendix B - Model Equations
Bernanke, B. S., M. Gertler, and S. Gilchrist (1999). The financial accelerator in a quantitative business cycle framework. In J. B. Taylor and M. Woodford (Eds.), Handbook of Macroeconomics, Volume 1C, Chapter 21, 1341–93. Amsterdam: North-Holland.
Calvo, G., A. Izquierdo, and R. Loo-Kung (2006). Relative price volatility under sudden stops: the relevance of balance sheet effects. Journal of International Economics, 69(1), 231–254.
Campa, J. and L. Goldberg (2005). Exchange rate pass-through into import prices. Review of Economics and Statistics, 87(4), 679–690.
Carlstrom, C.T. and T. S. Fuerst (1997). Agency costs, net worth, and business cycle fluctuations: a computable general equilibrium analysis. American Economic Review 87, 893–910.
Cespedes, L. F., R. Chang, and A. Velasco (2004). Balance sheets and exchange rate policy. American Economic Review, 94, 1183–1193.
Christiano, L. J., C. Gust, and J. Roldos (2004). Monetary policy in a financial crisis. Journal of Economic Theory 119(1), 64–103.
Cook, D. (2004). Monetary policy in emerging markets: Can liability dollarization explain contractionary devaluations? Journal of Monetary Economics, 51(6), 1155–1181.
Dedola, L. and G. Lombardo (2012). Financial frictions, financial integration and the international propagation of shocks. Economic Policy, 27(70), 319–359.
Devereux, M. B., P. R. Lane, and J. Xu (2006). Exchange rates and monetary policy in emerging market economies. The Economic Journal, 116, 478–506.
Devereux, M. B. and J. Yetman (2010). Leverage constraints and the international transmission of shocks. Journal of Money, Credit and Banking, 42, 71–105.
Devereux, M. B. and A. Sutherland (2011). Evaluating international financial integration under leverage constraints. European Economic Review 55(3), 427–442.
Eichengreen, B. and R. Hausmann (2005). Other People’s Money: Debt Denomination and Financial Instability in Emerging Market Economies, The University of Chicago Press.
Elekdag, S. and I. Tchakarov (2007). Balance sheets, exchange rate policy, and welfare. Journal of Economic Dynamics & Control, 31, 3986–4015.
Enders, Z., R. Kollmann and G. Muller (2011). Global banking and international business cycles. European Economic Review, 55, 407–426.
Faia, E. and T. Monacelli (2007). Optimal interest rate rules, asset prices and credit frictions. Journal of Economic Dynamics & Control, 31, 3228–3254.
Gertler, M., S. Gilchrist, and F. Natalucci (2007). External constraints on monetary policy and the financial accelerator. Journal of Money, Credit and Banking, 39, 295–330.
Gilchrist, S. (2004). Financial markets and financial leverage in a two-country world economy. In Banking Market Structure and Monetary Policy. Central Bank of Chile.
Greenwood, J., Z. Hercowitz, and G. Huffman (1988). Investment, capacity utilization, and the real business cycles. American Economic Review, 78 402–417.
International Monetary Fund (2011). World Economic Outlook: Tensions from the Two-Speed Recovery: Unemployment, Commodities, and Capital Flows. Washington, April.
Kalemli-Ozcan,S., B. Sorensen and S. Yesiltas (2011). Leverage across firms, banks and countries. Paper prepared for NBER-MIT Global Financial Crisis Conference, Bretton Woods, NH.
Martin, P. and H. Rey (2006). Globalization and emerging markets: with or without crash? American Economic Review, 96(5), 1631–1651.
Neumeyer, P.A., and F. Perri (2005). Business cycles in emerging markets: the role of interest rates. Journal of Monetary Economics, 52(2), 345–380.
Schmitt-Grohe, S. and M. Uribe (2007). Optimal simple and implementable monetary and fiscal rules. Journal of Monetary Economics, Elsevier, 54(6), 1702–1725.
We are grateful to an anonymous referee for comments and suggestions which have helped substantially improve the paper. We also would like to thank Christopher Adam, Lynne Evans, Hugh Metcalf, Marcus Miller, Joe Pearlman, Peter Sinclair, Mike Wickens and seminar participants at Newcastle University, participants at the Money, Macro and Finance Group (MMF) Annual Conference at the University of Bradford, the conference on “Monetary policy before, during and after the crisis” held at Heriot-Watt University, 29-30 September, 2011 and the Emerging Markets Group - ESRC Workshop on Global Linkages and Financial Crises at the Cass Business School, University of London, 27 April 2012. The usual disclaimer applies.
See, Reinhart and Rogoff (2009) for a comprehensive evaluation of the differences between the current and previous experiences of financial crisis.
Perri and Quadrini (2010) also utilize a two-country model in analyzing business cycle fluctuations across countries. However, in contrast to our model, the financial (credit) shock in their model is transmitted to the rest of the world through its effect on the borrowing capacity of firms and the resulting cost and thus employment implications. Other channels of international transmission of domestic shocks have also been investigated in the literature. These include international portfolio holdings of leverage constrained investors (Devereux and Yetman, 2010); binding enforcement constraints on credit supply (Devereux and Sutherland, 2011); syncronization of borrowing costs and credit spreads across countries (Dedola and Lombardo, 2012); and global banking (Enders et al. 2011). Our paper differs from these analyses in two major respects, in addition to many differences in the modelling structure. First, in contrast to our analysis where both financial and trade linkages are explicitly modelled and play a key role, financial interactions are treated as the main source of interdependence between countries in these studies. Second, unlike in the above mentioned studies, we explore the amplification of a global financial shock onto an emerging market economy by setting the model structure accordingly. Among the existing studies the one that is closest to our analysis is Gilchrist (2004) who explores the role of leverage in the transmission of shocks from developed to developing countries. Although the two models share a number of features as both are based on Bernanke et al. (1999), our model differs from Gilchrist (2004) in a number of important aspects. These include the teatment of financial accelerator mechanism, the modelling of the source of shocks as well as the choice of preferences among others.
Following Schmitt-Grohe and Uribe (2003), this premium is introduced for technical reasons to maintain the stationarity in the economy’s net foreign assets. As in Schmitt-Grohe and Uribe, we assume that the elasticity of the premium with respect to the aggregate debt is very close to zero (ΨD = 0.0075) so that the dynamics of the model are not affected by this friction.
There is considerable empirical evidence of pricing-to-market and incomplete exchange rate pass-through in small open economies. See, for example, Naug and Nymoen (1996) and Campa and Goldberg (2005).
This generates a gradual adjustment in the prices of goods in both markets, as suggested by Rotemberg (1982).
The idiosyncratic productivity is assumed to be distributed log-normally; log(ωt(k)) ∼
As in Curdia (2008), our specification of the debt contract between investors and entrepreneurs explicitly takes into account the misperception factor, which makes risk premium sensitive to the perception of investors. Curdia (2008) adopts a max-min criteria for the misperception factor so that during the sudden stop episode, the misperception factor is set to a constant value lower than 1. This implies that, in his calibration, the investors’ perception is constant for 2.5 years at a pre-set, lower value. In our case, however, we let the misperception factor to be an AR(1) process during the sudden stop episode such that the abrupt change in the perception of investors gradually goes back to the pre-shock level, rather than staying constant for a prolonged period.
It is assumed that the entrepreneurs consume an identical mix of domestic and foreign goods in their consumption basket as is given by the composite consumption index in equation (2).
The non-stochastic steady state of the model is solved numerically in MATLAB, and then the second order approximation of the model and the stochastic simulations are computed using Michel Juillard’s software Dynare. Details of the computation of the non-stochastic steady state and the stationary model equations are available upon request.
The values for openness in the existing literature range between 0.25 (Cook, 2004; Elekdag and Tchakarov, 2007) and 0.5 (Gertler et al., 2007). We chose to set a middle value of this range, but we conduct a sensitivity analysis regarding the value of openness in Section 4.2.2.
We carry out a series of sensitivity analyses in order to asses the robustness of our results under the benchmark calibration. In Section 4, we report the results regarding the degree of financial contagion, trade openness, and monetary policy parameters. We also conduct sensitivity checks with regard to the degree of exchange rate pass-through, and find that our main results are not sensitive to changes in these parameters. These are not reported due to space limitations.
These figures are decade averages for emerging Americas, emerging Asia, and emerging Europe between 2000-2010. Worldscope data (debt as a percentage of assets - data item WS 08236) are used for the leverage ratio. External risk premium is calculated as the difference between the lending and the policy rate for emerging market countries, where available, using data from Haver Analytics for the same time period. Variations in these parameters affect our results only quantitatively, but not qualitatively.
See Kalemli-Ozcan et al. (2011) for stylized facts on bank and firm leverage for 2000- 2009 for both advanced and emerging economies.
The magnitude of the shock is 1 percent, which causes outflow of capital by about 1.5 percent of GDP on impact.
Our analysis of the amplification of the foreign financial shock onto the domestic economy, as portrayed in Figures 3-8, is based on a 0.75 % negative shock to the perception of investors regarding the productivity of foreign enterpreneurs. This shock generates an increase in the risk premium by about 1 percent quarterly on impact in the domestic economy as in the case of a financial crisis of domestic origin so that the responses are comparable to those in Fig.1.
IMF (2011) shows that net capital inflows to emerging economies are highly correlated with global financing conditions, with global interest rates and risk aversion playing an important role.
The fall in output in the first quarter of 2009 as compared with a year earlier was 10.1, 10.2 and 13.8 per cent for Singapore, Taiwan and Turkey, respectively. Similarly, Germany and Japan, that are among the most open of mature economies, contracted by 6.9 and 8.8 per cent, respectively over the same period (The Economist, July 4th, 2009).
See Scmitt-Grohe and Uribe (2007) for an in depth discussion on using second order approximation to utility function to calculate the welfare.