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Publisher : Elsevier - Science Direct (الزویر - ساینس دایرکت)
Journal : Journal of Macroeconomics, Volume 39, Part A, March 2014, Pages 113–155
In contrast to industrialized countries, emerging market economies are characterized by pro- or acyclical monetary policies and high output volatility. This paper argues that those facts can be related to a long-run feature of the economy – namely, its institutional quality (IQL). The paper presents evidence that supports the link between an index of IQL (law and order, government stability, investment profile, etc.), and (i) the cyclicality of monetary policy, and (ii) the volatilities of output and the nominal interest rate. In a DSGE model, foreign investors that choose a portfolio of direct investment and lending to domestic agents, face a probability of partial confiscation which works as a proxy that captures IQL. The economy is hit by external shocks to demand for home goods and productivity shocks while its central bank seeks to stabilize inflation and output. In the long run, a lower IQL tends to discourage external liabilities. If there is a positive external demand shock, we observe an increase in output and real appreciation. The latter operates through two opposite channels. First, it directly increases the opportunity cost of leisure generating incentives to expand labor supply. Second, it reduces the real value of the debt denominated in foreign currency which stimulates consumption but contracts the labor supply. If the IQL is low, the economy attracts fewer loans for domestic consumers and shows a lower debt-to-consumption ratio in the steady state. This implies that the reduction of the real value of the debt caused by the real appreciation is smaller. Given this low wealth effect, the real appreciation leads to an expansion of the labor supply. Wages drop and inflation diminishes. The central bank reacts by cutting its policy rate to stabilize inflation and generates a negative comovement between output and the nominal interest rate (procyclical policy). As a corollary, negative correlations between policy rates and output are not necessarily an indicator of destabilizing polices even in the presence of demand shocks.
Monetary policies designed to stabilize business-cycle fluctuations are generally regarded as optimal (see, e.g., Woodford, 2001). In contrast to industrialized economies, emerging market economies (EMEs) are characterized by either procyclical or, at most, acyclical monetary policies and higher output volatility. In fact, several studies (see Lane (2003), also Section 2) have confirmed that central banks in the developing world tend to raise (cut) interest rates during recessions (expansions). On the other hand, it is well known that macroeconomic volatility is higher in EMEs (Mendoza (1991); also Section 2). Some works have linked these facts by suggesting that procyclical monetary policies might have contributed to the larger economic fluctuations observed in EMEs (Kaminsky et al., 2004 and Lane, 2003). This paper highlights the role of institutional quality as a factor behind such empirical regularities. It presents evidence that supports the link between the cyclicality of monetary policy and the quality of institutions. In a sample of 56 developed and developing economies, the correlation between output and the central bank’s (nominal) interest rate – a usual measure of the cyclicality of monetary policy – is directly related to an index of institutional quality (e.g., law and order, government stability, investment profile, etc.) widely used in the economic literature. That is, countries with strong institutions tend to show positive output-interest rate correlations (i.e., signals of countercyclical monetary policy), while countries with weak institutionality have negative correlations and follow policies usually characterized as procyclical. This result is robust with respect to a number of sensitivity exercises. On the other hand, there is a statistically significant and negative relationship between measures of the volatility of both output and interest rates and the proxy of institutional quality. This work extends a standard dynamic stochastic general equilibrium model with price rigidities by introducing foreign investors which choose a portfolio of foreign direct investment (FDI) and lending to domestic agents, and produce an export good. The economy is hit by external demand and productivity shocks and the central bank’s objective is to stabilize domestic inflation, output, and variations in the nominal exchange rate. The latter captures the case of managed float regimes frequently found in EMEs. Foreign investors face a probability of incurring an output loss (partial confiscation) which works as a proxy of institutional quality and affects the long-run level and composition of external liabilities and output. In particular, in the steady state, lower institutional quality discourages both FDI and lending in foreign currency to domestic agents, a prediction consistent with recent empirical evidence (Alfaro et al., 2005a, Alfaro et al., 2005b, Bussea and Hefeker, 2007, Faria and Mauro, 2009, Papaioannou, 2009, Wei, 2000 and Wei, 2006). From a quantitative viewpoint, the model does a satisfactory job of matching the sample variance–covariance matrix of output and the interest rate for both Indonesia and Switzerland, the economies with the lowest and highest levels of institutional quality in our sample. The model predicts a positive comovement between total output and the nominal interest rate at relatively high levels of institutional quality. The reaction of the central bank is to increase the interest rate when there is a positive external demand shock of home goods because inflation and output increase. In contrast, the central bank reacts by cutting the interest rate when there is a positive productivity shock in the domestically-owned sector. This occurs basically because inflation falls. If demand shocks mainly drive business cycles, a positive output-interest rate comovement arises. At relatively low levels of institutional quality, the model predicts a negative comovement between total output and the nominal interest rate. The impulse-response analysis shows that the key difference between high and low institutional quality relies on how the central bank reacts to external demand shocks. If there is a positive external demand shock, we observe an increase in output and a real appreciation (i.e., an increase in the relative price of home goods). The real appreciation operates through two opposite channels. On the one hand, under price stickiness, the necessary nominal appreciation lowers the consumer price level, generating a higher opportunity cost of leisure and, therefore, an incentive to expand labor supply. On the other, it reduces the real value of the debt denominated in foreign currency and thus stimulates both consumption and leisure causing a contraction of labor supply. If institutions are weaker, however, the economy attracts fewer loans for domestic consumers and shows a lower debt-to-consumption ratio in the steady state. This implies that the reduction of the real value of debt in foreign currency caused by the real appreciation is smaller. Given this low wealth effect, the real appreciation leads to an expansion of labor supply. As a result, wages drop and inflation diminishes. The central bank reacts, in this case, by cutting its interest rate to stabilize inflation and generates a procyclical monetary policy. Since the foreign-owned sector has a relatively small size under weak institutionality, productivity shocks from this sector do not play a crucial role. Besides, productivity shocks in the domestically-owned sector contribute by reinforcing the sign of the output-interest comovement. The net result is a negative link between the interest rate and output or, more generally, a lower correlation between those variables compared to the case of high institutional quality. Some explanations have been proposed to understand negative output-interest rate correlations in developing economies without either solid theoretical backgrounds or systematic empirical support (see also Section 2). The Asian crisis and other financial crises across EMEs triggered a strand of the literature on the optimal response of monetary policy to large external shocks.2 According to Calvo and Reinhart (2002), developing countries do not adopt countercyclical stabilization policies because when the domestic economy contracts, it experiences capital outflows, and central banks prefer to raise interest rates to compensate for the effect on the exchange rate, instead of leaving the currency value to float freely (fear of floating). In a static model with collateral constraints and currency mismatch, Devereux and Poon (2004) argue that a contraction of the monetary supply can be optimal if the economy is hit by a large external demand shock and the collateral constraint is binding, otherwise a countercyclical monetary policy would be recommendable. Yakhin (2008) contends that the degree of financial integration of the economy with the rest of the world could be a determinant of the optimal stance of monetary policy. In Céspedes et al. (2003), a procyclical monetary policy might be useful if an economy is characterized by balance-sheet effects and financial vulnerability (high indebtedness in foreign currency). The authors, however, contend that unrealistic values for the model parameters would be necessary for an economy to be in that situation. 3 There are several differences between those works and ours. First, we emphasize the role of institutional quality and how this affects external liabilities, the transmission of shocks, and the response of monetary policy. Second, our framework attempts to provide an argument which rationalizes why a central bank might follow a procyclical monetary policy not only when the economy faces large and negative (external) shocks (e.g., when a credit constraint is binding), but also during periods of economic normalcy. Third, this paper presents empirical evidence that relates institutional quality to both the procyclicality of monetary policy and output and interest rate volatilities, and, in turn, it discards other potential explanations. 4 Finally, this work tackles the task of explaining the linkage between the cyclicality of monetary policy and institutions from a positive perspective. The above mentioned works basically attempt to address the procyclical nature of monetary policy from a normative point of view. In that sense, our work complements the existing literature. The rest of the paper is organized as follows. Section 2 briefly summarizes the empirical evidence related to the main features and predictions of the model that is formulated in Section 3. Section 4 presents the solution and calibration of the model, the main results, the sensitivity analysis, and the empirical evidence consistent with the transmission mechanism. Section 5 concludes.
نتیجه گیری انگلیسی
This paper presents evidence that backs the linkage among the quality of institutions, the cyclicality of monetary policy, and the volatility of output and the nominal interest rate. Using a sample of 56 economies, the paper shows that unconditional and conditional measures of monetary cyclicality are significantly related to an institutional quality index. Alternative conjectures such as lack of either financial integration or central bank independence do not have empirical support as explained in Section 2. Countries with strong institutions usually exhibit positive output-interest-rate correlations, while EMEs tend to show weak institutionality accompanied with negative (or zero) correlations. The latter fact is usually understood as a sign of procyclical (or acyclical) monetary policies. Moreover, economies with weak institutionality also show a higher volatility of output and interest rates. This work proposes a simple stylized model to understand these facts. Foreign investors that face institutional risk are introduced in a simple dynamic stochastic model with price rigidities and a discretionary central bank that primarily seeks to smooth inflation and output fluctuations. Foreign agents invest directly into the economy and lend to domestic households that finance consumption and other expenditures. Foreign investors also face a probability of incurring an output loss (partial confiscation) which works as a proxy of institutional quality. For calibration purposes, Indonesia is chosen within the sample of countries because it shows the lowest average institutional quality index as well as the most negative output-interest-rate correlation. The model is parameterized to replicate some of its features, such as its external debt-to-output ratio and FDI-liability-to-output ratios. As a result of this, it can also match the highly negative correlation between output and interest rate and its GDP volatility. From a quantitative viewpoint, the model does a satisfactory work in matching the sample variance–covariance matrix of output and the interest rate for Indonesia and Switzerland (the latter with highest positive correlation). Consistent with empirical evidence (e.g., Alfaro et al., 2005a, Alfaro et al., 2005b and Papaioannou, 2009), one of the model’s prediction in the long run is that FDI and debt liabilities tend to be lower under low institutional quality. A key model prediction is the negative relationship between total output and the nominal interest rate at relatively low levels of institutional quality. If institutions are weaker, the economy attracts less foreign investment and lending to domestic agents. Consequently, the reduction of the real value of the debt in foreign currency caused by the real appreciation is smaller than the case of high institutional quality. Given this low wealth effect, when there is an export shock, the real exchange rate drops and expands the labor supply. As a result, wages drop and inflation diminishes. The central bank reduces the policy rate to stabilize inflation. The final outcome is a negative comovement between output and interest rate. On the other hand, since the foreign-owned sector is small under weak institutionality, productivity shocks from this sector do not play a crucial role. In the domestically-owned sector, productivity shocks only contribute by reinforcing the sign of the output-interest rate comovement. In sum, the overall result is a negative link between the policy rate and output or, more generally, a lower correlation between those variables compared to the case of high institutional quality. Any evaluation of the role that monetary policies play in countries with low institutional quality should not be restricted to the sign of the output-interest-rate comovement. Negative correlations between policy rates and output are not necessarily an indicator of destabilizing polices even in the presence of demand shocks. In this work we showed that such negative comovements can be perfectly consistent with a central bank which seeks to stabilize both inflation and output gap fluctuations in the context of weak institutionality.