Philippe Bacchetta

Currency Crises and Monetary Policy in an Economy with Credit Constraints

This paper presents a simple model of currency crises which is driven by the interplay between the credit constraints of private domestic firms and the existence of nominal price rigidities. The possibility of multiple equilibria, including a ‘currency crisis’ equilibrium with low output and a depreciated domestic currency, results from the following mechanism: If nominal prices are ‘sticky’, a currency depreciation leads to an increase in the foreign currency debt repayment obligations of firms, and thus to a fall in their profits; this reduces firms’ borrowing capacity and therefore investment and output in a credit-constrained economy, which in turn reduces the demand for the domestic currency and leads to a depreciation. We examine the impact of various shocks, including productivity, fiscal, or expectational shocks. We then analyze the optimal monetary policy to prevent or solve currency crises. We also argue that currency crises can occur both under fixed and flexible exchange rate regimes as the primary source of crises is the deteriorating balance sheet of private firms.

Consumption and Credit Constraints: International evidence

Abstract If some consumers are liquidity-constrained, aggregate consumption should be ‘excessively sensitive’ to credit conditions as well as to income. Moreover, the ‘excess sensitivity’ may vary over time. Using data for the United States, Canada, the United Kingdom, Japan and France, we find a substantial impact of credit aggregates on consumption in all countries considered. Moreover, the borrowing/lending wedge is a significant determinant of consumption in the United States, Canada and Japan. Using extended Kalman filtering techniques, we show that the excess sensitivity varies over time, with a clear tendency to decline in the United States.

Capital Markets and the Instability of Open Economies

This paper introduces a framework for analyzing the role of financial factors as a source of instability in small open economies. Our basic model is a dynamic open economy model with one tradeable and one non-tradeable good with the non-tradeable being an input to the production of the tradeable. We also assume that firms face credit constraints, with the constraint being tighter at a lower level of financial development. The two basic implications of this model are the following: first, economies at an intermediate level of financial development are more unstable than either very developed or very underdeveloped economies. This is true both in the sense that temporary shocks have large and persistent effects and also in the sense that these economies can exhibit stable limit cycles. Thus, countries that are going through a phase of financial development may become more unstable in the short run. Second, in economies at an intermediate level of financial development, full financial liberalization may actually destabilize the economy. On the other hand, foreign direct investment does not destabilize.

Why do Consumer Prices React Less than Import Prices to Exchange Rates

It is well known that the extent of pass-through of exchange rate changes to consumer prices is much lower than to import prices. One explanation is local distribution costs. Here we consider an alternative, complementary explanation based on the optimal pricing strategies of firms. We consider a model where foreign exporting firms sell intermediate goods to domestic firms. Domestic firms assemble the imported intermediate goods and sell final goods to consumers. When domestic firms face significant competition from other domestic final goods producing sectors (e.g., the non-traded goods sector) we show that they prefer to price in domestic currency, while exporting firms tend to price in the exporters currency. In that case the pass-through to import prices is complete, while the pass-through to consumer prices is zero.

A simple model of monetary policy and currency crises

This paper analyzes the optimal interest rate policy in currency crises. Firms are credit constrained and have debt in domestic and foreign currency, a situation that may easily lead to a currency crisis. An interest rate increase has an ambiguous effect on firms since it makes more difficult to borrow and may decrease the foreign currency debt burden. In some cases it is actually best to decrease the interest rate. We also show how these issues are related to the development of the financial system.

Do Capital Market Imperfections Exacerbate Output Fluctuations

We develop a dynamic general equilibrium macroeconomic model where a proportion of firms are credit constrained due to asymmetric information. In general, a macroeconomic shock has additional effects created by a reallocation of funds between credit-constrained and unconstrained firms. We show that the output response to shocks is not necessarily amplified, however, and can be dampened by the presence of asymmetric information. This depends on the impact of the shock on the composition of external and internal funds for credit-constrained firms. Furthermore, we show that it is important to distinguish between firms’ collateral and firms’ cash flow in determining the dampening or amplifying effect of agency costs.

Exchange-of-Information Clauses in International Tax Treaties

This paper examines bilateral double taxation treaties, with an emphasis on information exchange among tax authorities. A major objective is to understand which countries are more likely to sign a tax-relief treaty and when information-exchange clauses will be added to a treaty. A simple model with two asymmetric countries and repeated interactions among governments is used. The paper shows that no information exchange clause may be added to a tax treaty when there is a reciprocity requirement, when there is a high cost of negotiation, when there is a cost of providing information, or with one-way capital flows. It is also shown that an information clause increases the gains from a tax relief treaty, but may make it less sustainable.

Capital Controls with International Reserve Accumulation: Can This Be Optimal?

Motivated by the Chinese experience, we analyze a semi-open economy where the central bank has access to international capital markets, but the private sector has not. This enables the central bank to choose an interest rate different from the international rate. We examine the optimal policy of the central bank by modelling it as a Ramsey planner who can choose the level of domestic public debt and of international reserves. The central bank can improve savings opportunities of credit-constrained consumers modelled as in Woodford (1990). We find that in a steady state it is optimal for the central bank to replicate the open economy, i.e., to issue debt financed by the accumulation of reserves so that the domestic interest rate equals the foreign rate. When the economy is in transition, however, a rapidly growing economy has a higher welfare without capital mobility and the optimal interest rate differs from the international rate. We argue that the domestic interest rate should be temporarily above the international rate. We also find that capital controls can still help reach the first best when the planner has more fiscal instruments.

Optimal seigniorage and financial liberalization

Abstract This paper analyzes the effect of financial integration for countries relying on the taxation of their domestic financial system. A two-country model with overlapping generations and explicit financial intermediation is used. Goverments derive revenues from seigniorage and set optimally, but non-cooperatively, the rate of inflation and the level of required reserves on bank deposits. A financial liberalizations leads to lower reserve ratios, higher inflation rates, and larger stocks of government debt. When the liberalization is anticipated, governments may temporarily increase the reserve ratios before the liberalization occurs. (JEL F30, E60)

Liberalization of Capital Movements and of the Domestic Financial System

This paper analyzes the dynamic impact of a joint liberalization of capital movements and of the domestic financial sector. Both a simultaneous and a sequential liberalization are examined in an overlapping-generations model with a q-theory of investment. A liberalization generally leads to an initial period of capital inflows followed by capital outflows. It also increases investment and causes an overshooting in share prices. Furthermore, the interest rate level before a liberalization will usually not indicate the direction of net capital flows. Copyright 1992 by The London School of Economics and Political Science.