Foreign Currency Debt And Exchange Rate Regimes In The Prospective .

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Foreign Currency Debt and Exchange Rate Regimes in theProspective Monetary Union of the ECOWAS CountriesLacina Balma1Abstract: Corporates in developing countries often issue foreign currency denominated debt.Liability dollarization carries additional risks since large devaluation of the real exchange rate cansuddenly raise default probabilities. We use a small open economy Dynamic Stochastic GeneralEquilibrium model with the “balance sheet channel” similar to Bernanke et al (1999) explicitlymodeled to study the implications of liability dollarization for the conduct of monetary policy.Bayesian estimation methods are employed and the model is estimated for the EconomicCommunity of the West African States (ECOWAS). We find that a floating regime offers greaterstability than a hard peg. Results are robust to different model parameters, except for the degree ofopenness, highlighting the role of demand-switching effects.Keywords: Corporate debt default risk; Exchange rate policy; DSGE models; Bayesian estimation;ECOWASJEL Classification: E3, E4, F31I am indebted to the organizers of the 2013 summer university on DSGE model hosted by theLAREFI, Université de Bordeaux 4, which inspired this research, and to the participants foruseful comments on an early version of this paper.Research Consultant, African Development Bank. Email : [email protected]

1. IntroductionDeveloping economies like those in the ECOWAS often finance the accumulation of physicalcapital by issuing foreign currency denominated debt, a phenomenon referred to as “original sin”by Eichengreen and Hausmann (1999). For the first time, many of them are able to borrow ininternational financial markets, selling so-called Eurobonds, which are usually denominated indollars or euros. The World Bank Debtor Reporting System (DRS) confirms that in 2010 around30 percent of developing countries’ external net debt inflows are denominated in developedcountries currencies such as the U.S dollar. More recently, countries such as Angola, Cote d’Ivoire,Gabon, Ghana, Namibia, Nigeria, Rwanda, Senegal, Seychelles, and Zambia have tapped intointernational debt markets (figure 1 and 2). In total, more than 20 percent of the 48 countries insub-Saharan Africa have sold Eurobonds. 2 Moreover, a few corporate entities in sub-SaharanAfrica (SSA) have also successfully issued Eurobonds. For example, Guarantee Trust Bank inNigeria raised 500 million dollar in a five-year bond offering in 2011, and Ghana Telecom issued300 million dollar in five-year bonds in 2007 (Masetti, 2013).The factors propelling the reversal include the dire infrastructure gaps, and large borrowing needswhich often exceed aid flows and domestic saving.3 In addition, local currency bond markets inSSA in general are at a nascent stage of development, which otherwise could offer alternativesources of finance. First, market capitalization of government securities and corporate bonds aretypically much lower than those of other developing, emerging and developed economies (figure3). Second, there is more apparent disparity for corporate bond in bond. Indeed, the averagecorporate capitalization of corporate bond was 1.8 percent of GDP in 2010 for sub-Saharan Africa,whereas the figure was generally much larger for other developing and emerging economies. Alsoevident is that the local currency bond market in the region is denominated by governmentsecurities, with a share of 89.2 percent of the total market capitalization, compared to the share ofcorporate bond which stands at just 10.8 percent in 2010 (Sy, 2013).42Kenya, Tanzania and Uganda are expected to join the crowd in the near future.See Foster and Briceño-Garmendia (2010).4In recent year, there is a reversal. The government securities market capitalization has tended to fall,from 18.7 percent of GDP in 2006 to 14.1 percent in 2009. When taken together, the share of corporatebond in total bonds has increased rapidly from 5.1 percent in 2006 to 10.8 percent in 2010 (Mu, 2013).32

GabonChileSouth AfricaAngolaBrazilNigeriaEMBIG AsiaEMBIG EuroMoroccoMexicoItalyGhanaEMBIG AfricaIrelandEMBIG EuropeEMBIGZambiaHungarySpainSenegalPortugalCote d'IvoireGreeceGabon (2007)Angola (2012)Ghana (2007)Zambia (2012)Nigeria (2011)Namibia (2011)Rwanda (2013)Seychelles (2006)Senegal (2009)02468100122000Size of offering, million dollarsSovereign bond yields, percentFigure 2: Bond selling by sub-SaharanAfrican countries in internationalcapital marketsSource: Sy (2013)Figure 1: Yields on Eurobonds issued by subSaharan African countriesSource: Bloomberg L.P.300Bond market capitalization1000250200150100500Government securities marketsCorporate bond marketsFigure 3: Local Bond Market Comparisons, 2010 (percent GDP)Source: World economic and financial surveys*Excluding South Africa3

When credit-constrained corporates’ assets are denominated in domestic currency while liabilitiesare denominated in foreign currency, an exchange rate depreciation is likely to wreak havoc ontheir net worth by raising the debt burdens and making it more expensive to repay. 5 As a result,firms’ costs of capital increase, leading to a contraction in equilibrium investment. In addition,whatsoever access firms in these countries have on world capital markets, their borrowing tendsto be collateralized and subject to nontrivial finance premiums above the international lending rate.The effect of foreign currency denominate debt along with the (sizeable) risk premium give rise towhat is referred to as the “financial accelerator mechanism” pioneered by Bernanke et al (1999).6Even though a depreciation can potentially boost export volumes by promoting competitiveness,it can also trigger a potentially severe recession due to balance sheet effects.The paper aims to study how the balance sheet channel can shape the choice of appropriateexchange rate policy. In the model, credit-constrained firms are exposed to foreign currencydenominated debt and their borrowing constraints depend on the state of their balance sheets. Anunexpected nominal exchange rate depreciation is likely to increase their default risk, andpotentially offset the standard expansionary effects of a depreciation. The model is calibrated andestimated for Nigeria, Ghana and the West African Economic Monetary Union (WAEMU).7,8Specifically, we compare the performance of two exchange rate regimes: Pure fixed and floatingregimes.95The 1997 Asian crisis is a good example. The crisis was in part due to the maintenance by thesecountries of soft peg for too long, which encouraged external borrowing and led to excessive exposure toforeign exchange risk in both the financial and corporate sectors. Monetary authorities have beenreluctant to allow their currency to float freely—the “Fear of Floating” argument advanced by Calvo andReinhart (2001)6We use interchangeably the “financial accelerator mechanism” the “balance sheet channel” to expressthe same phenomenon.7The ECOWAS is comprised of Benin, Burkina Faso, Cape-Verde, Cote-d’Ivoire, The Gambia, Ghana,Guinea, Guinea-Bissau, Liberia, Mali, Niger, Nigeria and Sierra Leone, Senegal and Togo. TheWAEMU is a subset of the ECOWAS and encompasses 8 countries, namely Benin, Burkina Faso, Coted’Ivoire, Guinea, Mali, Niger, Senegal and Togo. Five non-WAEMU countries including The Gambia,Ghana, Guinea, Nigeria and Sierra Leone have created the West African Monetary Zone (WAMZ) in2003, which later is meant to merge with the WAEMU and form the currency union of the ECOWAS.8Sy (2013) shows that after the middle income African countries with a relatively developed corporateexternal bond market capitalization, the WAEMU zone display a significant one, yet at infancy level.Diouf and Boutin-Dufresne (2012) and Sy (2007) provide a detailed description of the local bond marketin the WAEMU region.9These two regimes are in line with the surge in the corner solutions in recent year around the world in thewake of the Asian crisis. See Frankel, Schmukler, and Servén (2001) and Fischer (2001), Obstfeld and4

In the wake of the financial crisis of the 1990s, a number of studies have considered issues relatingthe balance sheet channel with the conduct of monetary policy (Krugman (1998); Aghion,Bacchetta, Banerjee (200, 2001)). Recent studies carried out by Cook (2004), Eleckdag andTchakarov (2007), Cespedes et al. (2004), Devereux et al. (2006) and Gertler et al. (2007) haveanalyzed the credit channel in developed and emerging economies with well-functioning financialmarkets and the role of exchange rate policy. The results of these studies allow us to classify theminto two groups: Cook (2004), Eleckdag and Tchakarov (2007) found a greater role for the fixedexchange rate in macroeconomic stabilization of the emerging economies, while Cespedes et al.(2004), Devereux et al. (2006) and Gertler et al. (2007) emphasize the primacy of the flexibleexchange rate regime on the fixed exchange rate, which is consistent with the recommendation ofthe standard Mundell-Fleming framework.From a theoretical point of view, these studies are subject to criticisms because they assume acomplete exchange rate pass through, perfect mobility of capital and flexible domestic importprices. The assumption of complete pass-through is in stark contrast with the well-establishedempirical evidence that deviations from the law of one price for traded goods prices are large andpervasive. Empirical evidence by Akofio-Sowah (2009) on Sub-Saharan Africa (SSA) and onLatin American countries points to incomplete pass-through as a result of low inflationaryenvironments. Within the SSA region, the Common Market for Eastern and Southern Africa(COMESA) countries have the highest inflation and therefore the exchange rate pass-through inthose countries is 25 to 50 percent higher than that in the WAMZ, the WAEMU and the CentralAfrican Economic and Monetary Community (CEMAC). In the same vein, Diop et Fall (2011)also assume incomplete pass-through in a dynamic stochastic general equilibrium model to studywhich exchange rate regime would be relevant for the ECOWAS members. They find that a fixedregime is likely to foster more stability without undermining growth performances of thosecountries. With respect to this assumption, our framework is similar to theirs, but different in thatit focus on the balance sheet channel of monetary transmission.Rogoff (1995), for interesting discussion on the corner solutions hypothesis. Since the intermediate case,soft peg, varies within a band with the pure fixed and floating exchange rate regime being its lower andupper bound respectively, we do not explicitly implement the experiment under this regime; rather weprovide a perception of its effects drawing on the two mentioned regimes.5

The main findings of this paper can be summarized as follows. We find that a floating regimeoffers greater stability of corporates’ balance sheet in the presence of risk premium shocks andleads to greater business cycle stability than pure fixed regime. These findings are consistent withthe conventional framework of Mundell-Fleming which highlights that free float acts as a shockabsorber. It follows that the standard policy recommendation holds: small open economies withgreater exposure to being adversely affected by external disturbances should implement a float.The results are robust to important model parameters, yet affected by the degree of openness ofthe economy, which reveals the role of demand switching effects.The rest of the paper is structured as follows. Section 2 describes the model. Section 3 explainsthe calibration and econometric strategies used to estimate the parameters of the model, theestimation results and impulse response functions of the shocks. Finally, section 4 conductsrobustness checks and section 5 concludes.2. The ModelThe core framework in this paper is a typical new Keynesian small open economy DSGE modelwith nominal rigidities, which is key for investigation of monetary policy. It builds on Sangaré(2013), focusing on three aspects of the model: first it accounts for incomplete pass-through(Monacelli, 2005); second, it includes the financial accelerator mechanism à la Bernanke et al.(1999) by linking domestic firms’ borrowing conditions—the cost of capital induced by the riskpremium—to the state of their balance sheets; and third, the model assumes imperfect capitalmobility. The phenomenon of the original sin is captured in the framework by assuming that animportant part of the debt in the economy is denominated in foreign currency. Through theborrowers’ balance sheets, the financial accelerator mechanism works to amplify and ensure thepersistence of shocks to the economy. We then extend on these model features to include habitformation in consumption utility (Justiniano and Preston, 2004) to allow for a smoothedconsumption path and to avoid unrealistically drastic adjustments. Furthermore, the extendedmodel exhibits two types of firms encompassing firms adopting forward-looking behavior on theone hand, and firms endowed with backward-looking behavior in price setting on the other.Previous studies consider only the presence of forward-looking firms thus overlooking the wellestablished evidence on the rule of thumb price-setting behavior of some firms (see Fuhrer andMoore (1995) and Rudd and Whelan (2005) among others). In addition, while most studies focuses6

on emerging Asian countries, this paper is interested in linking financial market frictions with thechoice of monetary policy regime in the prospective currency union of the founding members ofthe ECOWAS or a subset of countries of this.The framework contains the salient features of the standard new Keynesian small economy DSGEmodel with respect to the optimizing behavior of the microeconomic units, entrepreneurs, capitalproducers and household, government, the monetary authority and a foreign sector. Householdssupply labor to entrepreneurs and consume tradable goods that are produced both domestically (H)and abroad (M). Credit-constrained firms borrow both in foreign currency and in domesticcurrency (see chart 1). Their demand for capital depends on their net worth via payment of a riskpremium. This is the key aspect of the financial accelerator channel.Chart 1: Flow Chart of the EconomyCENTRAL BANKInterest rateExternal BorrowingProfitsDepositsBANKWholesale LERSLump-sum taxWORLDCapitalGOVERNMENTREST OF THEImportsCAPITAL PRODUCERSInvestment GoodsPublic GoodsA continuum of monopolistically competitive firms (retailers) operating through domestic andforeign market set their prices in the local market on a staggered basis à la Calvo (1983). This7

helps to explain inflation inertia and output persistence. Capital accumulation is subject toadjustment costs. The deviation from the law of one price is introduced in the model to accountfor the assumption of incomplete pass-through.2.1. HouseholdsThe domestic small open economy is populated by a continuum of infinitely-lived maximizinghouseholds. The intertemporal utility function of the households depends positively onconsumption 𝐶𝑡 relative to an external habit formation ℎ𝐶𝑡 1 and negatively on labor supply 𝐿𝑡 : (𝐶𝑡 ℎ𝐶𝑡 1 )1 𝜎 (𝐿𝑡 )1 )𝐸0 𝛽 ( 1 𝜎1 𝑡(1)𝑡 0Where 0 𝛽 1 is the discount factor; 𝜎 0 is the coefficient of relative risk aversion (or inverseof the intertemporal elasticity of consumption, and 0 is the inverse elasticity of labor supply; 𝐶𝑡is a CES function defined over domestic goods and imported goods:1𝜃𝐶𝑡 [(1 𝑎) (𝐶𝐻,𝑡 )𝜃 1𝜃𝜃𝜃 1 𝜃 1𝜃1𝜃 𝑎 (𝐶𝑀,𝑡 )](2)Where 𝐶𝐻,𝑡 and 𝐶𝑀,𝑡 stand for the usual CES aggregators of the quantities of domestic and foreigngoods respectively, and 𝜃 0 is the elasticity of substitution between both types of goods; 0 𝑎 1 is the share of foreign-produced goods in the consumption bundle reflecting the degree ofopenness of the domestic economy:10𝜒 1𝐶𝐻,𝑡 1( 0 𝐶𝐻,𝑡 (𝑗) 𝜒𝑑𝑗 )𝜒𝜒 1𝜒 1and 𝐶𝑀,𝑡 1( 0 𝐶𝑀,𝑡 (𝑗) 𝜒𝑑𝑗 )𝜒𝜒 1,𝜒 1 is the elasticity of substitution between the different varieties of goods and 𝐶𝐻,𝑡 (𝑗) standsfor the consumption of the variety 𝑗 of the domestic and foreign good. The consumer price indexassociated with equation (2) is defined as:10We pay attention to this parameter later in this paper for robustness check purpose.8

1𝜃 1𝑃𝑡 [(1 𝑎)(𝑃𝐻,𝑡 )𝜃 1 𝜃 1 𝑎(𝑃𝑀,𝑡 )](3)In the same vein, the corresponding aggregate prices over the varieties 𝑗 of domestic and foreigngoods are given by:𝑃𝐻,𝑡 1( 0 𝑃𝐻,𝑡 (𝑗)𝜒 1𝑑𝑗 )1𝜒 1and 𝑃𝑀,𝑡 1( 0 𝑃𝑀,𝑡 (𝑗)𝜒 1𝑑𝑗 )1𝜒 1.Optimal allocation of expenditures between domestic and foreign goods can be written as𝑚𝑖𝑛𝐶𝐻,𝑡, 𝐶𝐻,𝑡,𝐶𝑡 𝑃𝐻,𝑡 𝐶𝐻,𝑡 𝑃𝑀,𝑡 𝐶𝑀,𝑡 𝑃𝑡 𝐶𝑡1𝜃𝑠. 𝑡 𝐶𝑡 [(1 𝑎) (𝐶𝐻,𝑡 )𝜃 1𝜃1𝜃 𝑎 (𝐶𝑀,𝑡 )𝜃𝜃 1 𝜃 1𝜃]This expenditure minimization on domestic and foreign goods yields the demand functions fordomestically produced and imported goods as in the following:𝐶𝐻,𝑡 (1 𝑎) (𝑃𝐻,𝑡 𝜃𝑃𝑡)𝐶𝑡 ;𝐶𝑀,𝑡 𝑎 (𝑃𝑀,𝑡 𝜃𝑃𝑡)𝐶𝑡(4)The household budget constraint is given by:𝑤𝑃𝑡 𝐶𝑡 𝑅𝑡 1 𝐵𝑡 1 𝑅𝑡 1Ψ𝐷,𝑡 1 𝑆𝑡 𝐷𝐻,𝑡 1 𝜏𝑡 𝑊𝑡 𝐿𝑡 𝐵𝑡 𝑆𝑡 𝐷𝐻,𝑡 Λ𝑡 𝑇𝑡(5)Following Devereux et al. (2006), we assume that households purchase public bond in localcurrency 𝐵𝑡 at a nominal interest rate 𝑟𝑡 𝑅𝑡 1, and that part of their debt is denominated inforeign currency, 𝐷𝐻,𝑡 . The nominal interest rate associated to the latter debt is 𝑟𝑡𝑤 𝑅𝑡𝑤 1,while Ψ𝐷,𝑡 stands for the country borrowing premium (detailed description of that follows later inthis section). We introduce this country borrowing premium to account for the assumption ofimperfect international capital mobility and partly for technical reasons on the stationarity of thetotal net foreign indebtedness (Schmitt-Grohe and Uribe 2003). Following Sangaré (2013), thecountry borrowing premium is a modified version of Adolfson et al. (2008) as follows:Ψ𝐷,𝑡 (𝑑𝑡 , 𝐸𝑅, 𝑍𝑡 ) 𝑟𝑡 𝑟𝑡𝑤 𝑍𝑡 𝑒𝑥𝑝 (𝜓𝐷 (𝑆𝑡 𝐷𝑡𝑌𝑃𝑡9)) 𝐸𝑡 (𝑆𝑡 1 𝑃𝑡𝑆𝑡 𝑃𝑡 1),

Where 𝑑𝑡 𝑆𝑡 𝐷𝑡𝑌𝑃𝑡is the total debt to GDP ratio in period t, 𝐸𝑅𝑡 𝑆𝑡 1𝑆𝑡is changes in the exchangerate and 𝑅𝑤 is the risk-free world interest rate. Ψ𝐷,𝑡 is an increasing function of the total net foreign,indebtedness (Ψ𝐷,𝑡 ) 0 and Ψ𝐷,𝑡 (0,0) 1; 𝐷𝑡 is total debt of the country and comprisesd𝐷𝐻,𝑡 (the households foreign debt) and 𝐷𝐸,𝑡 (the entrepreneurs foreign debt) (𝐷𝑡 𝐷𝐻,𝑡 𝐷𝐸,𝑡 ).We elaborate on 𝐷𝐸,𝑡 in the next sections; 𝜓𝐷 is the elasticity of the country’s borrowing premiumwith respect to the debt and 𝑍𝑡 stands for a random shock:𝑍𝑡 𝐴𝑅(1), log(𝑍𝑡 ) 𝜁𝑧 𝑍𝑡 1 𝜀𝑧,𝑡 , with 𝜀𝑧,𝑡 𝑖. 𝑖. 𝑑(𝑜, 𝜎𝜀2𝑍 ).Besides the financial borrowing, the flow of the households’ income is composed of nominalwages 𝑊𝑡 from labor services and profits Λ𝑡 of monopolistically competitive firms they own. Theyalso receive transfers 𝑇𝑡 from government, which represents the lump sum tax payment 𝜏𝑡 . 𝑆𝑡𝑤stands for the nominal effective exchange rate and 𝑅𝑡 1 𝐵𝑡 1 𝑅𝑡 1Ψ𝐷,𝑡 1 𝑆𝑡 𝐷𝐻,𝑡 1 is the totalgross refund on the borrowings contracted by the households at 𝑡 1. The representative household chooses the set {𝐶𝑡 , 𝐿𝑡 , 𝐵𝑡 , 𝐷𝐻,𝑡 }0 that maximizes its intertemporalutility (1) subject to its budget constraint (5). The first order conditions of the maximizationproblem are given by:(𝐿𝑡 )η Wt 𝑄𝑡Pt1 𝛽𝑅𝑡 𝐸𝑡 ((6)𝑄𝑡 1 𝑃𝑡)𝑄𝑡 𝑃𝑡 1𝑄𝑡 𝛽𝑅𝑡𝑤 Ψ𝐷,𝑡 (dt , Zt )𝐸𝑡 (𝑄𝑡 1(7)𝑃𝑡 𝑆𝑡 1)𝑃𝑡 1 𝑆𝑡(8)Where 𝑄𝑡 (𝐶𝑡 ℎ𝐶𝑡 1 ) 𝜎The first order conditions of the consumer’s problem are standard and can be written in a loglinearized form as:10

wt pt 𝜂𝐿𝑡 𝐶𝑡 𝜎(𝐶 ℎ𝐶𝑡 1 )1 ℎ 𝑡(9)ℎ11 ℎ(𝑟 𝐸𝑡 𝜋𝑡 1 )𝐶𝑡 1 𝐸𝑡 𝐶𝑡 1 1 ℎ1 ℎ𝜎 (1 ℎ ) 𝑡(10)Where 𝜋𝑡 1 is the next period’s overall inflation in the economy defined as 𝑃𝑡 1 𝑃𝑡 . Condition(9) and (10) can be viewed as the marginal rate of substitution between consumption and laborwhile (8) is the famous Euler equation of consumption. Combining equations (7) and (8) yieldsthe usual condition of the Uncovered Interest Parity (UIP) adjusted for the risk premium.2.2. The Real Exchange Rate, the Terms of Trade, and Incomplete PassThroughOne of the recent developments in open economy New Keynesian DSGE is the modeling of thedeviation of prices from the Law of one price referred to as the law of one price gap (Monacelli,2005). The claim is that monopolistically competitive firms exert some power on price of goodsthey import and distribute thus creating a distortion between the domestic and foreign prices ofthese imported goods when expressed in the same currency. It is this distortion that is referred toas the law of one price gap. It is assumed that the Law of one price does not hold for import goodsin this study.In this section, we are concerned with the link between inflation, the real exchange rate (RER) andterms of trade (TOT). We define three types of inflation in the economy: the domestic inflationπ̂ 𝐻,𝑡 which stems from price setting rules of domestic goods by firms, the imported inflation π̂ 𝑀,𝑡resulting from price setting rules of imports by firms, and finally the consumer price-basedinflation 𝜋̂ 𝑡 . Taking the log-linearized form of equation (3) and then taking the first-differenceyields equation (11) which is a weighted average of the two types of inflation we just mentioned.π̂ 𝑡 (1 𝑎)π̂ 𝐻,𝑡 𝑎π̂ 𝑀,𝑡(11)The terms of trade is defined as follows:𝑇𝑂𝑇𝑡 𝑃𝑀,𝑡(12)𝑃𝐻,𝑡11

Log-linearizing (12) around the steady-state yields the following:̂ 𝑡 𝑝̂𝑀,𝑡 𝑝̂𝐻,𝑡𝑡𝑜𝑡̂ 𝑡 𝜋̂𝑀,𝑡 π̂ 𝐻,𝑡 . We then substitute this in (11) to getTaking the first-difference yields Δ𝑡𝑜𝑡̂𝑡π̂ 𝑡 π̂ 𝐻,𝑡 𝑎 Δ𝑡𝑜𝑡(13)From equation (13), it is possible to say that the difference between the total and domestic inflationrates is proportional to the terms of trade and that proportionality increases with the degree ofopenness of the domestic economy.Furthermore, we define the real exchange rate 𝑅𝐸𝑅𝑡 through the following relationship:𝑅𝐸𝑅𝑡 𝑆𝑡 𝑃𝑡𝑤(14)𝑃𝑡Under the hypothesis of complete pass-through the price of import in domestic currency is givenby 𝑃𝑀,𝑡 𝑆𝑡 𝑃𝑡𝑤 , which means that any idiosyncratic change in exchange rate completely spillsover into domestic prices. In contrast, under incomplete pass-through —as it is the case in thisstudy— the law of one price does not holds and therefore 𝑃𝑀,𝑡 𝑆𝑡 𝑃𝑡𝑤 .The Law of one price gap is therefore given by the ratio of the foreign price index in terms ofdomestic currency to the domestic currency price of imports.𝐿𝑂𝑃𝐺𝑡 𝑆𝑡 𝑃𝑡𝑤𝑃𝑀,𝑡(15)Note that the law of one price holds only if 𝐿𝑂𝑃𝐺𝑡 1 . Otherwise, the Law of one price does nothold. It is worth mentioning that through this study, the law of one price holds for exports. This isa realistic assumption since it assumes that the economies we are concerned with in this study areprice takers in international markets for their exports. In contrast, importing firms aremonopolistically competitive and have a small degree of pricing power in the domestic market, anovelty of Monacelli (2005)’s model (see section 2.3 for more details on that). This means thatwhen retail firms sell imported goods to domestic consumers, they charge a mark-up over their12

costs, creating a wedge between the world market price of foreign goods and domestic currencyprice of these goods.Ultimately, the link between the Law of one price gap, the terms of trade and the real exchangerate is obtained by combining the log-linearized versions of (12), (13), (14) and (15) as follows:𝑟𝑒𝑟̂𝑡̂ 𝑡 (1 𝑎)𝑡𝑜𝑡̂𝑡 𝑙𝑜𝑝𝑔(16)Equation (16) deserves some explanations. It shows that the deviation from aggregate PPP isdriven by two factors. The first one is due to the heterogeneity of consumption basket between̂ 𝑡 , as long as 𝑎 1domestic goods and imported goods, an effect captured by the term (1 𝑎)𝑡𝑜𝑡. For 𝑎 1, in fact, the two aggregate consumption baskets coincide and relative price variationsare not required in equilibrium. The second source of deviation from PPP is due to the deviation̂ 𝑡.from the law of one price, captured by movements in 𝑙𝑜𝑝𝑔2.3 . FirmsThere are four types of entrepreneurs in the economy: wholesale entrepreneurs, capital producers,domestic goods retailers operating both on domestic and international markets, and imported goodsretailers2.3.1 Wholesalers and the Financial AcceleratorThere is a continuum of perfectly competitive wholesale firms 𝑗 [0,1] producing wholesalegoods with a Cobb-Douglas-type technology of production:𝑌𝑡 𝐴𝑡 𝐾𝑡 (𝑗)𝛼 𝐿𝑡 (𝑗)1 𝛼(17)Where 𝐴𝑡 is a technology shock following an AR(1) process:2𝑙𝑜𝑔(𝐴𝑡 ) 𝜁𝐴 𝑙𝑜𝑔𝐴𝑡 1 𝜖𝐴,𝑡 , where 0 𝜁𝐴 1 is a persistence parameter and 𝜖𝐴,𝑡 𝑖. 𝑖. 𝑑(𝑜, 𝜎𝜖,𝑡)𝐾𝑡 is the capital factor and 𝐿𝑡 is the labor factor supplied by households; 0 𝛼 1 is the share ofthe capital factor in the production function.Following Bernanke et al. (1999), we assume that firms are credit-constrained and neveraccumulate enough funds to fully self-finance their capital acquisitions. This assumption is taken13

into account by assuming that firms have a finite expected horizon. Each survives until the nextperiod with a probability 𝜈 . Accordingly, the expected horizon is given by 1 (1 𝜈). We assumethat firms borrow only in foreign market and that their borrowing is denominated in foreigncurrency (Eleckdag and Tchakarov, 2007). Borrowings from foreign lenders are subject topayment of a risk premium denoted by Φ. If 𝑄𝑡 and 𝑁𝑡 represent the price of capital andentrepreneur’s net worth respectively, then the entrepreneurs’ net worth is expressed in each periodt, by the following budget constraint:𝑄𝑡 𝑁𝑡 1 𝑄𝑡 𝐾𝑡 1 𝑆𝑡 𝐷𝐸,𝑡 1(18)Where 𝑆𝑡 is the exchange rate and 𝐷𝐸,𝑡 1 is the entrepreneur’s foreign debt in period 𝑡 1.Equation (18) tells us that the entrepreneur’s net worth is the difference between it asset andliability. Any unanticipated depreciation of the exchange rate raises the cost of capital and worsensthe entrepreneur’s net worth. The framework assumes that entrepreneurs are risk neutral andchoose the level of capital 𝐾𝑡 1 and the associated borrowing 𝐷𝐸,𝑡 1 which maximize their profits.When the optimality conditions satisfying the financial contract between the borrower and theforeign lender are reached, 11 then the expected return on capital (𝐸𝑡 𝑅𝐾,𝑡 1 ) is equal to the marginalcost of the external fund, that is, the gross interest rate of the rest of the world 𝑅𝑡𝑤 adjusted forchanges in the exchange rate𝑆𝑡 1𝑆𝑡plus country-specific risk-premium Ψ𝐷,𝑡 and external financepremium Φ.𝐸𝑡 𝑅𝐾,𝑡 1 Φ {𝑅𝑡𝑤 (Ψ𝐷,𝑡 )𝐸𝑡 (𝑆𝑡 1 𝑃𝑡𝑆𝑡 𝑃𝑡 1)}(19)The external finance premium Φ depends on the entrepreneur’s net worth𝑃𝑡 𝑁𝑡 1𝑄𝑡 𝐾𝑡 1. In general, itvaries inversely with the entrepreneur’s net worth. Therefore, the greater the share of capital theentrepreneur can either self-finance or finance with collateralized debt, the smaller the expectedN γbankruptcy costs and, the smaller the external finance premium: Φ (q Kt 1 ) where γ is thet t 111Interested readers should refer to Bernanke et al (1999) for more details on the optimization problemsarising from the financial contracts between the two parties.14

elasticity of the external finance premium with respect to entrepreneurs’ net worth capital ratio,and qt is the price of capital in real terms ( q t QtPt) and (Φ)′ 0; Φ(1) 1 .Equation (19) provides the basis for the financial accelerator since it links movements in theborrower financial position to the marginal cost of funds and, hence, to the demand for capital.Now we link the return to the entrepreneur’s capital, 𝑅𝐾,𝑡 , with the marginal productivity of capital𝑚𝑝𝑐𝑡 . The gross return on investment per unit of capital is measured as the sum of the marginalproductivity of capital arising from the production process plus non depreciated value of capital:𝑅𝐾,𝑡 𝑞𝑡 1 𝑚𝑝𝑐𝑡 (1 𝛿 )𝑞𝑡(20)Where 𝛿 is the rate of depreciation of capital.Finally, the relation describing the evolution of entrepreneurial net worth 𝑁𝑡 1 is worthmentioning. It can be expressed as a function of the value of entrepreneurial firms’ capital, net ofborrowingcosts𝑆𝑡 𝑃𝑡 1𝑅𝑡𝑤 Ψ𝐷,𝑡 (𝑆𝑡 1𝑃𝑡carried) (𝑞𝑁𝑡)𝐾𝑡 1 𝑡 𝛾overfromthepreviousperiod,𝜈 [𝑅𝐾,𝑡 𝑞𝑡 1 𝐾𝑡 (𝑞𝑡 1 𝐾𝑡 𝑁𝑡 )], plus the net worth left by firms who did not survive,( 1 𝜈 ) Ω𝑡 :𝑆𝑡 𝑃𝑡 1𝑁𝑡 1 𝜈 [𝑅𝐾,𝑡 𝑞𝑡 1 𝐾𝑡 𝑅𝑡𝑤 Ψ𝐷,𝑡 (𝑆𝑡 1𝑃𝑡) (𝑞𝑁𝑡)𝐾 𝛾𝑡 1 𝑡(𝑞𝑡 1 𝐾𝑡 𝑁𝑡 )] (1 𝜈)Ω𝑡(21)Where 𝜈 is the proportion of firms who survive in the economy and Ω𝑡 is the net worth of firmswho do not survive and leave the economy each time.Equation (21) clearly shows that the evolution of entrepreneurs’ net worth is driven by the returnon investment 𝑅𝐾,𝑡 and the world interest rate on borrowings, supplemented with country-specificrisk premium (𝑅𝑡𝑤 Ψ𝐷,𝑡 ). As the interest rate increases, the entrepreneur is not inclined to borrowin the foreign market, everything else being equal, and this reduces the availability of resource inthe next period. The last source of fluctuations in the firms’ net worth is the variation of theexchange rate whose depreciation reduces the net worth.2.3.2 Capital Producers15

The activity pertaining to the role of capital producers in the economy consists of repairingdepreciated capital goods and building new ones, all this being carried over in a competitive way.The production of new capital is subject to adjustment costs while the repair of old capital goodsis not as in Eisner and Strotz (1963), Lucas (1967) and Gertler et al. (2006). It is also assumed thatthere is not possibility of substitution between old capital and new capital. The claim is that for theold capital to be productive, it should be repaired.Both activities—old capital maintenance and production of new capital—use as input a compositeinvestment good that is composed of domestic and foreign final goods:1𝜃𝜃 1𝜃𝐼𝑡 [(1 𝑎) (𝐼𝐻,𝑡 )1𝜃 (𝑎) (𝐼𝑀,𝑡 )𝜃𝜃 1 𝜃 1𝜃](22)The associated investment price index is denoted by 𝑃𝑡 . The number of units of investment goodsrequired to replace the depreciated capital is 𝛿𝐾𝑡 whose costs are bore by the entrepreneurs whoown the capital stock. Therefore the amount of the investment good used for the construction ofnew capital goods is given by 𝐼𝑡 𝛿𝐾𝑡 .The adjustmen

exchange rate in macroeconomic stabilization of the emerging economies, while Cespedes et al. (2004), Devereux et al. (2006) and Gertler et al. (2007) emphasize the primacy of the flexible exchange rate regime on the fixed exchange rate, which is consistent with the recommendation of the standard Mundell-Fleming framework.

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