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Peering Through Monetary Mist: Macroeconomic Effects of Monetary Policy under Borderless World of Financial and Labor Market Suchanan Chunanantatham January 8, 2007 Presentation guide Introduction: How did it all begin? What is it that I intend to study? How distinguish this thesis over the others in the same area? Model summary What is the building block behind the results? Results of the study What is the answer to the questions at hand? Conclusion What is the implication learned? Introduction Objective 1 To study whether financial market integration strengthens or weakens the ability of policymakers to stabilize the economy using macroeconomic policy Motivation A widespread acceleration in financial liberalization To the extent that such integration is a policy choice, investigating its benefit and cost seem to be an obvious and promising direction for research Among many aspects, the implication in term of macroeconomic policy is chosen. Theoretical framework Classic workhorse model developed by Mundell(1962) and Fleming (1963) Mixed results and drawbacks Contribution New open economy macroeconomic model developed by Ofstfeld and Rogoff (1995) Introduction Objective 2 To explore role played by labor market integration on the effect of financial market integration on the adjustment of the economy to unanticipated changes in monetary policy Motivation Most of works in international policy transmission assume no migration of labor across countries. Through it alleviates the theoretical analysis, it is clearly at variance with empirical evidences Contribution Extending the model to include international labor flow would render the model to be more practical while allow for more detail study if financial market integration Model Consumer -Choose consumption, bond, -Each individual consumption of and money holding to maximizedifferentiated products need to be utility subject to budget chosen so as to minimize the cost constraint of attaining aggregate consumption 1 1 H Ms H H s t N Cs H H N H N C Max H 1 1 Ps ptH ( z ) ctH ( z ) H CtH , where z=h,f H H H ,D ,M ,F s t s t Subject to N H DtH (1 itH1 ) N H DtH1 N H M tH1 N H M tH wtH N H Pt 1 Pt H N H CtH Pt H N H I tH Pt H N H Z tH N H tH Pt H N H Tt H n H 1 1 1 1 P p (h) dh p ( f ) df H H where N H Z tH N H I tH 1 2 2 0 n N H is given. Producer Government - Price adjustment mechanism -Assume government Free entry and exit spending is zero + Inelastic labor supply -Gov’t budget constraint Zero profit ( M t 1 M t ) Tt - Pricing rule psH wsH Pt Numerical results In what follows, quantitative properties based on the previous chapter’s qualitative framework are explored. Computational experiments No closed-form solution simulating a calibrated version of the log-linear system numerically Method of undetermined coefficient The results are interpreted by using impulse response analysis Numerical results Combination of experiments The plots, which represent the propagation of asymmetric shock on various macroeconomic variables, are classified into four cases Case 1: Prior to Labor Market Integration 1.1 Degree of Capital mobility: high 1.2 Degree of capital mobility: Low X Case 2: Subsequent to Labor Market Integration 2.1 Degree of Capital mobility: high 2.2 Degree of capital mobility: Low X Shock Follow Sutherland (1996), the shocks considered in this thesis are permanent and asymmetric. Numerical results Case 1: Prior to international labor migration First objective: “how the degree of international financial market integration matters for the dynamics of the model in the aftermath of monetary shock with the labor market separated between nations.” Numerical results 1.1 High degree of capital mobility with incomplete labor market integration: The benchmark case Nominal interest rate 0.2 0.5 0.45 0.1 0.4 Percent deviation from steady state Percent deviation from steady state 0 0.35 0.3 -0.1 0.25 -0.2 0.2 -0.3 Home 0.15 Foreign 0.1 -0.4 0.05 -0.5 0 -1 0 1 2 3 4 5 6 7 8 -1 0 1 2 3 4 5 6 7 8 Years after shock Years after shock Low barrier in making international flows of funds only one interest rate An asymmetric shock the interest rates are leaved unaffected by monetary shock from each country Numerical results General price index 1 0 0.9 -0.1 0.8 -0.2 Percent deviation from steady state Percent deviation from steady state 0.7 -0.3 0.6 -0.4 0.5 -0.5 0.4 -0.6 0.3 -0.7 0.2 -0.8 0.1 -0.9 0 -1 -1 0 1 2 3 4 5 6 7 8 -1 0 1 2 3 4 5 6 7 8 Years after shock Years after shock Flexible-price model home price index increases by somewhat the same amount as a change in money supply. Numerical results Wage (or price of individual differentiated products) 1 0 0.9 -0.1 0.8 -0.2 Percent deviation from steady state Percent deviation from steady state 0.7 -0.3 0.6 -0.4 0.5 -0.5 0.4 -0.6 0.3 -0.7 0.2 -0.8 0.1 -0.9 0 -1 -1 0 1 2 3 4 5 6 7 8 -1 0 1 2 3 4 5 6 7 8 Years after shock Years after shock The symmetry of both countries individual prices of goods in each country (either own-produced or imported) behave like its general price index. pt Pt ˆ H ˆ H N HCH ˆ H Q Ct N FC F ˆ F Q Ct 0 So, apparently individual prices in home, which is equal to wage in the model where flexible prices guarantee zero profit, rise by one percent as well. Numerical results Implication: Real wage remains unchanged at the level that generates steady state full employment, i.e., we have zero deviation of outputs from steady state ˆ ytH 0or Yt H 0 ˆ Obviously, where full employment is assured by wage and price flexibility, monetary policy has impact that would be predicted from the basic quantity theory of money. That is, it is only price level in an economy, not real economic variables, such as output and employment, that is affected by quantity of money. Contradict to Sutherland (1996) where there is price-rigidity, the general level of price will change in proportion to the change in money stock, leaving the real side of economy unchanged Numerical results Consumption index (and consumption of individual goods) 0.08 0.01 0.07 0 Percent deviation from steady state Percent deviation from steady state 0.06 -0.01 0.05 -0.02 0.04 -0.03 0.03 -0.04 0.02 -0.05 0.01 -0.06 0 -0.07 -0.01 -0.08 -1 0 1 2 3 4 5 6 7 8 -1 0 1 2 3 4 5 6 7 8 Years after shock Years after shock Once-and-for-all step change from its initial value to a new long-run steady state level. Numerical results The main reason for flat consumption: Unchanged real interest no incentive to reallocate consumption overtime ˆ ˆ ˆ CtH1 CtH 1 it H Et Pt 1 Pt H ˆH ˆ In other words, a country will wish to smooth consumption in the situation where a subjective discount factor is equal to the market discount factor C H t 1 C (1 rt ) t H H Not surprisingly, in presence of an efficient ways of accumulating financial wealth, countries can gain more opportunity for consumption- smoothing, as confirmed in the above two graphs. Numerical results 2 Exchange rate 1.8 1.6 Percent deviation from steady state 1.4 1.2 Exchange rate dynamic 1 ˆ H ˆ F ˆH ˆF Ct Ct it it 1 0.8 ˆ ˆ ˆ Et M tH M tF 0.6 0.4 0.2 0 -1 0 1 2 3 4 5 6 7 8 Years after shock The relative money supply and change in relative consumption level no change once-and-for-all step change in nominal interest rate exchange rate must also jumps immediately to its long-run level. Indeed, home currency depreciates (foreign currency appreciates) to about 2 percent. Numerical results No-exchange-rate-overshooting property of the model Exchange rate dynamic is virtually identical to the central equation of the flexible-price monetary model of exchange rates s m m y y i i i i ste s m m y y ste According to above equation, once domestic currency is expected to depreciate over the coming period, the today demand for domestic currency will fall, causing an increase in exchange rate immediately. Consequently, Dornbusch-type exchange rate overshooting does not essentially occur in this model. Numerical results Quantity of funds transferred 0.1 0.02 Percent deviation from steady state consumption value Percent deviation from steady state consumption level 0.08 0 0.06 -0.02 0.04 -0.04 0.02 -0.06 0 -0.08 -0.02 -0.1 -1 0 1 2 3 4 5 6 7 8 -1 0 1 2 3 4 5 6 7 8 Years after shock Years after shock Domestic agents are accumulating foreign bonds (increase in net claim on the rest of the world) as the depreciation in domestic currency gives rise to national current account surplus Numerical results 1.2 Low degree of capital mobility with incomplete labor market integration How does presence of imperfect financial market integration affect the dynamics of the model? 1 i ˆ ˆt H 1 it F Et Et 1 Et N H C H Et I tH1 I tH ˆ ˆ ˆ ˆ (1) Equation (1) states that the yield differential between domestic and foreign bond( i.e., the nominal interest differential less the expected depreciation of the nominal exchange rate) is proportional to expected rate of change of the cross-border flow of funds. Numerical results 1 iˆt H 1 iˆt F Et Et 1 Et N H C H Et IˆtH1 IˆtH ˆ ˆ Algebraically, with higher value of , A negative expected rate of change in cross-border flow of funds 0.2 0.5 0.45 0.1 0.4 Percent deviation from steady state Percent deviation from steady state 0 0.35 0.3 -0.1 A higher negative in international -0.2 0.25 0.2 nominal interest rate differential -0.3 0.15 0.1 -0.4 0.05 -0.5 0 -1 0 1 2 3 4 5 6 7 8 -1 0 1 2 3 4 5 6 7 8 Years after shock 2 Years after shock 1.8 1.6 Percent deviation from steady state A bigger expected rate of change 1.4 in value of home currency 1.2 1 0.8 the initial impact on exchange rate of monetary expansion 0.6 when international financial market are segmented 0.4 0.2 would be smaller 0 -1 0 1 2 3 4 5 6 7 8 Numerical results Intuitively, the central implication of imperfect capital mobility is that domestic and foreign bonds become differentiated and can, therefore, pay different rate of return. With low capital mobility, The tendency for money supply to induce higher asset accumulation in domestic economy relatively higher downward pressure on relative yield of domestic asset First, nominal interest rate of each country becomes more diverge, i.e., nominal interest rate rises in home while falls in foreign. Second, since one component of domestic yield is capital gain arisen from change in exchange rate, the higher domestic yield fall implies that expected depreciation is relatively higher. Numerical results Price (individual prices of home product and wage) 1 0 0.9 -0.1 0.8 -0.2 Percent deviation from steady state Percent deviation from steady state 0.7 -0.3 0.6 -0.4 0.5 -0.5 0.4 -0.6 0.3 -0.7 0.2 -0.8 0.1 -0.9 0 -1 -1 0 1 2 3 4 5 6 7 8 -1 0 1 2 3 4 5 6 7 8 Years after shock Years after shock In keeping parity of purchasing power among the countries, the marginally increase in E home general price index rises by less Numerical results Consumption (and consumption of individual goods) 0.08 0.01 0.07 0 Percent deviation from steady state Percent deviation from steady state 0.06 -0.01 0.05 -0.02 0.04 -0.03 0.03 -0.04 0.02 -0.05 0.01 -0.06 0 -0.07 -0.01 -0.08 -1 0 1 2 3 4 5 6 7 8 -1 0 1 2 3 4 5 6 7 8 Years after shock Years after shock Home consumption index rises sharply and then declines afterward. Fall in real interest rate in home incentive for domestic consumers to bring consumption forward in time When market interest rate differs from time-preference rate, the motivation to smooth consumption is modified by an incentive to tilt the consumption path. Another reason: lower increase in price level Numerical results First Investigation Money shock under different degrees of financial market integration: Before international labors migration Perfectly integrated Imperfectly integrated 0.2 0.1 Percent deviation from steady state Unchanged interest rate - Interest rate 0 -0.1 -0.2 0.08 -0.3 0.07 -0.4 Percent deviation from steady state 0.06 0.05 -0.5 0.04 - sharply and afterward -1 0 1 2 3 4 Years after shock 5 6 7 8 0.03 0.02 0.01 0 Once-and-for-all in C -0.01 -1 0 1 2 3 4 5 6 7 8 2 Years after shock 1.8 1.6 Percent deviation from steady state Once-and-for-all in E + E by less 1.4 1.2 1 1 0.8 0.9 0.6 0.8 Percent deviation from steady state 0.4 0.7 0.2 0.6 0 Price more + -1 0 1 2 3 4 5 6 7 8 Price less 0.5 Years after shock 0.4 0.3 0.2 0.1 0 -1 0 1 2 3 4 5 6 7 8 Years after shock Output: unchange Output: unchange ˆ ytH 0or Yt H 0 ˆ Numerical results In other words, at any degree of labor market integration, it would be sufficient to establish the financial market integration as the factor that reduces volatility of interest rates and increases in volatility of prices and exchange rate. Hence, along the lines of Mundell-Fleming model and Sutherland (1996), the monetary policy effect toward exchange rate tends to be stronger, the higher is the degree of international capital mobility. On the other hand, while it enhances the effect on exchange rate, its effect on output deteriorates as perfectly flexible prices and wages bring about the classic neutrality property of monetary policy. Numerical results Case 2: Subsequent to international labor migration Second objective “ Whether implications of international capital mobility for the macroeconomic effects of monetary policy are sensitive to the extent of integration in international labor market.” Numerical results Comparing between incomplete and complete labor market integration, it go without saying that the presence of international labors resettlement does not significantly alter the way any of macro variables response to shock from what is analyzed in the last section. As before, the implications of lowering in trading friction in international financial transaction on monetary policy effects work through the interaction of relative asset return and exchange rate Numerical results 1 it H ˆ 1 it F Et Et 1 Et ˆ ˆ ˆ ˆ ˆ N H C H Et I tH1 I tH After the lower impediments to cross-country capital flows are introduced, the fall in relative yield from holding assets in different countries is smaller. This, simultaneously, means two things. The deviation of interest differential between domestic and foreign bond becomes narrower 0.4 Because of the higher expected inflation in domestic economy as a result of greater Percent deviation from steady state 0.2 0 -0.2 monetary-induce exchange rate depreciation in -0.4 Home the case where home agents can easily switch -0.6 places to invest their assets 0.25 the borrowers and lenders add inflation -0.8 Percent deviation from steady state 0.2 -1 premium to interest rate. Foreign -1.2 0.15 -1 0 1 2 3 4 5 6 7 8 Years after shock Ultimately, an expansion in money supply 0.1 in home will raise interest rate when financial 0.05 0 market integration is highly complete. -0.05 “expected inflation effect” -0.1 -1 0 1 2 3 4 5 6 7 8 Numerical results 1 iˆt H 1 iˆt F Et Et 1 Et ˆ ˆ ˆ ˆ N H C H Et I tH1 I tH The magnitude of an increase in depreciation expectation is getting smaller. In contrast to the case where a nation’s capital market is less loosen up, lower expected depreciation generates dramatically higher monetary-induced increase in exchange rate, as confirmed by the following diagram. 4.5 Percent deviation from steady state 4 3.5 3 2.5 2 1.5 1 0.5 0 -1 0 1 2 3 4 5 6 7 8 Years after shock Numerical results How are things different in the presence of global linkages in labor market? 1 iˆt H 1 iˆt F Et Et 1 Et ˆ ˆ ˆ ˆ N H C H Et I tH1 I tH The nominal exchange rate increases by more from an symmetric shock in a relative money supply, as compared to the case previous to migration. It appears from the equation that the relative difference between returns from holding assets of home and foreign country becomes smaller after labors relocate from home to foreign. The smaller yield differential, then, implies that the expected domestic currency depreciation happens to be less significant in the world of high worldwide labor mobility. So, with lower depreciation expected, it is necessary for the impact effect of monetary change on exchange rate to be larger , i.e., higher depreciation (in either low or high degree of financial market integration) if labors are allowed to migrate. Numerical results Armed with the dynamics of exchange rate, we can determine the effect of monetary policy change on other macro variables. If we compare to the world where difficulties in undertaking position in oversea financial market is more important, asymmetric shock in money supply causes home general price index and wage (or price of individual goods) to rise by more as it produces a bigger rate of home currency depreciation. 3.5 3 Percent deviation from steady state Percent deviation from steady state 3 2.5 2.5 Price 2 Wage 2 1.5 1.5 1 1 0.5 0.5 0 0 -1 0 1 2 3 4 5 6 7 8 -1 0 1 2 3 4 5 6 7 8 Years after shock Years after shock Numerical results How are things different in the presence of global linkages in labor market? The direct effect of a change in the location of production on price index of that country: After a given amount of home labors move to foreign country, steady state value of home total outputs, as well as the number of varieties home produces, decline. This raises positive effect of expansionary monetary policy on home price. “Price index effect”: Price index in a particular region would tend to be higher, the lower is the share of production sector in that region. Accordingly, we can notice a larger rise in home price index, as compared to the circumstances before labor market integration. Numerical results Wage: Because a substantial depreciation in home currency creates a higher demand for home products at the expense of foreign products, moving of home labors to foreign country would appear to raise home wages up higher after the disturbance hits the economy. “Home market effect” With the vertical labor supply curve, the producers in location with larger demand for its product would have to pay a higher nominal wage. Therefore, an asymmetric change in monetary policy would cause a higher rise in home wage rate if labor is mobile across regions. Numerical results Dynamics of consumption and current account Expansionary monetary policy in home gives rise to a fall in consumption, instead of raising it as it does in the case ahead of home emigration. • This is so because it generates a much higher rise in price level, which implies a lower purchasing power and thus the incentive to spending. • Plus, the fact the home interest rate fall by less as a result of money supply increase means that agents will wish to consume relatively more in the future, rather than now. Consequently, in the below panel, as the disturbance strikes, home consumption declines once labor is highly mobile across countries. In fact, home consumption climbs down by more, 0 Percent deviation from steady state thus leading to greater current account surplus -2 when the two financial markets are highly -4 -6 integrated. • Of course, this is attributed to the higher -8 increases in domestic price + smaller fall in -10 domestic interest falls when countries become less -12 isolated to the global financial market -14 -1 0 1 2 3 4 5 6 7 8 Numerical results Second Investigation: Implications of international capital mobility for the effects of monetary policy: After international labors migration 0.4 Perfectly integrated Imperfectly integrated Percent deviation from steady state 0.2 0 -0.2 -0.4 -0.6 interest rate - Interest rate -0.8 -1 4.5 -1.2 -1 0 1 2 3 4 5 6 7 8 Percent deviation from steady state 4 Years after shock 3.5 3.5 E more + E less 3 2.5 2 1.5 Percent deviation from steady state 3 1 2.5 0.5 2 0 Price more Price less -1 0 1 2 3 4 5 6 7 8 + Years after shock 1.5 1 0.5 0 0 -1 0 1 2 3 4 5 6 7 8 Years after shock Percent deviation from steady state -2 C more + C less -4 -6 -8 -10 -12 Output: unchange Output: unchange -14 -1 0 1 2 3 4 5 Years after shock 6 7 8 ˆ ytH 0or Yt H 0 ˆ Summary of simulation results In the nutshell, the simulated results carried out at different degrees of financial and labor market integration ultimately indicate that 1) The way macroeconomic variables response after money shock hit economy obviously differs between economy with low and high capital mobility Cases i, r C , c( z ) E P, p( z ) y( z ), Y Financial market integration (i) Imperfect integrated labor market - - + + 0 (ii) Perfectly integrated labor market -* + + + 0 Summary of simulation results Accordingly, although the approach taken here differs radically from that of traditional Mundell-Fleming model in that it allows policy issues to be analyzed by mean of full- fledged micro-founded dynamic model, the two approach share some implications as both models appear to predict that the nominal exchange rate effect of monetary policy tend to increase in the world where capital mobility is far above the ground. At the same time, the flexile-price NOEM model developed in this paper and the quantity theorist also are not extremely far apart in terms of output implication of monetary policy. Eventually, money is all that matters for change in nominal, not real, income, as reflected clearly in the basic quantity theory of money. Summary of simulation results 2) Another interesting results concern the impact of having a particular amount of labors migrates from home to foreign country. The simulation results suggest that quite the same pattern still applies even after the possibility of shift in labor location is incorporated. Cases i, r C , c( z ) E P, p( z ) y( z ), Y Financial market integration (i) Imperfect integrated labor market - - + + 0 (ii) Perfectly integrated labor market -* + + + 0 As a consequence, regardless of the condition in terms of linkage in labor market of each nation, the international financial market integration does show a consistent and dependable effect toward the behavior of economy in the upshot of shock in money supply. The end Thank you

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