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Selim Elekdag and Ivan Tchakarov are Economists at the IMF in the Research and the Asia and Pacific Departments, respectively. Alejandro Justiniano is currently an Economist at the Board of Governors of the Federal Reserve although much of this paper was completed while he was at the IMF. We are grateful to Gian Maria Milesi-Ferretti, Robert Flood, Douglas Laxton, Alessandro Rebucci, and an anonymous referee for helpful comments and discussions.
Krugman (1999) and Aghion, Bacchetta, and Banerjee (2001), among others, argue that exchange rate and interest rate fluctuations—through balance sheet constraints impacting investment spending—affect borrowers in EMCs disproportionately more than entrepreneurs in industrialized economies. Calvo and Reinhart (2000) argue that the reluctance to implement a pure float (“fear of floating”) could be justified by the fact that large exchange rate movements may devastate corporate and financial balance sheets, because of large outstanding foreign currency-denominated debt obligations. Therefore, one way EMCs apparently deal with such vulnerabilities is by attempting to minimize exchange rate fluctuations. In this context, Elekdag and Tchakarov (2004) show that when the foreign currency–denominated debt-to-GDP ratio exceeds a certain threshold, the welfare costs associated with a pure float could exceed those of managed exchange rate regimes.
In fact, we consider a continuum of households indexed with h ∊ [0,1]. However, in a symmetrical equilibrium, these households will behave identically; therefore, we suppress this index.
Given the aggregate price index defined in equation (3), the individual consumption demands for each good are CFt = (1 − γ)ρtCt / st and CHt = γρtCt / pt.
As in Smets and Wouters (2003), in the log-linearized version of the model, the mean value of λt is perturbed by an AR(1) disturbance, which can be interpreted as a cost-push shock to inflation.
However, in the model, we use the general specification of the optimal choice for pt(j), which is
where the discount factor is formally defined as λt, t+τ = βCt / Ct+τ.
Bernanke, Gertler, Gilchrist (1999) provide further details on the increasing relationship between the entrepreneur’s capital-to-net worth ratio and the external finance premium.
Equivalently, we could have used the leverage ratio—also referred to as the (foreign) debt-to-equity ratio defined as sD/pN, based on qK/PN = 1 + sD/pN, as implied by equation (18).
More specifically, it is the cost associated with monitoring, and it is an increasing function of the risk premium; see Bernanke, Gertler, and Gilchrist (1999) for the full exposition.
The term (1 − ηt) may also be interpreted as the entrepreneur’s bankruptcy rate. In the log-linearized version of the model, ηt is perturbed from its mean by an AR(1) disturbance, which—as in Christiano, Motto, and Rostagno (2003)—could be interpreted as a shock to the rate of destruction of entrepreneurial financial wealth mimicking the bursting of a stock market bubble.
More specifically, the domestic bond clearing condition implies that bt = 0. The six exogenous variables—
There are also clear advantages when it comes to model comparisons because the models are not required to be nested and numerical methods for the computation of the marginal likelihood permit constructing posterior model probabilities. These probabilities can in turn be used for model averaging, thereby producing parameter estimates that also explicitly incorporate model uncertainty. Furthermore, as emphasized by Smets and Wouters (2003), the use of Bayesian methods provides greater stability to optimization algorithms relative to maximum likelihood.
All series are extracted from Datastream International. Korea was chosen primarily because of data availability and the fact that it is an EMC that is not a net hydrocarbon or primary commodity exporter.
Nonetheless, we use observations from 1988 to 1989 for the initialization of the Kalman filter although these observations are not used in the computation of the likelihood and the estimation of the parameters.
Under the market average exchange rate system introduced in March 1990, the won was allowed to float against the U.S. dollar within a daily trading range of the weighted average of the previous day’s rates in the interbank market.
It might be argued that we should have restricted ourselves to a period of either pure float or managed float. Although Markov switching methods might allow for incorporating the transition to an alternative exchange rate policy, our limited sample prevents us from considering the estimation under the two regimes. Furthermore, this would entail estimating a nonlinear model.
The J. P. Morgan EMBIG series code is JPSSGKOR Index.
As argued in Smets and Wouters (2003), these parameters present difficulties in the estimation unless the absolute values of the time series are taken into account through the definition of the steady state. Furthermore, the adjustment cost parameter, θF*, is calibrated because it primarily serves to overcome the unit root problem in open economy models. In the working paper version of this paper (Elekdag, Justiniano, and Tchakarov, 2005), we have considered an alternative calibration for β that does not affect any of our conclusions.
Recall that v = [Ψ’(k)/Ψ(k)]k and k = qK/pN.
With these assumptions, equations (14), (15), and (21) imply that It = Kt, qt = ρt and
Relatedly, it is encouraging that our estimates are in the range of values used previously by calibration-based studies of the financial accelerator mentioned above. Furthermore, our results are also consistent with those of Meier and Mtiller (2006).
The median estimate of the capital-to–net worth ratio, k, was 1.76, implying a (foreign currency–denominated) debt-to-capital ratio of about 43 percent, consistent with the industry-level evidence discussed above. Also as discussed above, this is one of the key parameters that underpins the external finance premium; see Bernanke, Gertler, and Gilchrist (1999) for further details.
Recall that the EMBIG stripped spread hit 940 basis points at end-August 1998.
The average for the EMBIG from inception until the expiration of the IMF-supported program averaged about 321 basis points.
The import-to-GDP ratio was calculated for Korea using annual data from 1990 to 2003, using IMF International Financial Statistics series 98C and 99B.
More specifically, Ω = Φ′′(δ)δ/Φ′(δ), and as do Smets and Wouters (2003), we calibrate the depreciation rate, δ, to 0.025.
Finally, we ask how the models presented above compare with one in which the financial accelerator mechanism is shut down, that is, v → 0. We find that the marginal likelihood implies that the posterior odds favor the model with the financial accelerator fully operational (v ⋙ 0) by a ratio of 13 to 1.