528 views

Uploaded by obserwatorfinansowy.pl

save

You are on page 1of 34

in an open economy∗

Marcin Kolasa† Giovanni Lombardo‡

January 18, 2010

Abstract

This paper analyzes the optimal monetary policy in a two-country DSGE model with producer cur-

rency pricing and financial frictions. We show that if credit markets do not work perfectly, strict PPI

targeting is excessively procyclical in response to positive productivity shocks. The related welfare losses

are non-negligible, especially if financial imperfections interact with such frictions as nontradable produc-

tion and wage stickiness. Foreign currency debt denomination affects the optimal monetary policy: it

should be less contractionary in response to favourable domestic productivity disturbances and more so

if productivity shocks originate abroad. We also find that central banks should allow for deviations from

price stability to offset the effects of balance sheet shocks. While financial frictions substantially decrease

attractiveness of all price targeting regimes, they do not have a significant effect on the performance of

a monetary union agreement. Finally, nominal wage targeting is found to be fairly robust also in the

presence of credit frictions.

**Keywords: financial frictions, open economy, New Keynesian model, optimal monetary policy
**

JEL Codes: E52, E61, E44, F36, F41

1 Introduction

The New Keynesian model, which can be considered as a workhorse model for modern monetary policy

analysis, assumes that financial markets work perfectly and so the interest rate set by central banks uniquely

determines the cost of credit for borrowers. The recent financial crisis has exposed the lack of realism of

this simplifying assumption and revived interest in business cycle models with financial frictions. Due to the

path-breaking contributions from the 1990s, of which the most frequently cited are Bernanke et al. (1999)

and Kiyotaki and Moore (1997), the quantitative framework was already at hand. What needed to be done

was a normative analysis of how financial frictions affect the optimal monetary policy.

A number of recent papers have addressed this issue in a closed economy setup. For instance, Curdia and

Woodford (2008) extend the basic New Keynesian monetary model to allow for a spread between interest

rates faced by savers and borrowers. They demonstrate that if spreads are purely exogenous, the optimal

policy conduct does not differ substantially from the frictionless case. Allowing for endogenous spreads (in

an ad hoc way, i.e. by making them dependent on borrowers’ debt) affects this conclusion only modestly. In

particular, complete price stabilization is still very close to the optimal policy. Furthermore, adjusting the

intercept in the Taylor rule by changes in credit spreads improves upon an unadjusted rule.

A more structural contribution is offered by Carlstrom et al. (2009), who incorporate agency costs into

a standard New Keynesian model. Since agency costs manifest themselves as endogenous mark-up shocks,

maintaining price stability is not optimal in response to productivity shocks. However, it is very close to

optimal even if agency costs are quite severe. A similar conclusion is reached by Demirel (2009) and De Fiore

∗ The views presented in this paper are those of the authors and not necessarily of the institutions they represent.

† NationalBank of Poland, e-mail: marcin.kolasa@nbp.pl.

‡ European Central Bank, e-mail: giovanni.lombardo@ecb.int.

1

et al. (2009), who introduce costly state verification into a model with a direct credit channel a’la Ravenna

and Walsh (2006), in which firms need to borrow in advance to finance production.

Overall, this line of the literature suggests that if financial markets do not work perfectly, the central

bank has an incentive to depart from full price stability in response to productivity shocks. However, the

marginal welfare gain of neutralizing the credit friction distortion is rather low, so strict inflation targeting

is not far from optimal.

While the big advantage of the literature surveyed above is that it offers an analytical characterization of

the results, its focus is on models that are very simple. They abstract from endogenous capital formation,

which may have nontrivial consequences, given that financial frictions are considered to be particularly

relevant for investment decisions. Also, they do not address open economy issues and other potentially

important frictions. On the other hand, there is a number of papers incorporating financial frictions into

a more sophisticated framework, but not discussing what the optimal policy should do. Instead, they offer

welfare-based comparisons of alternative simple policy regimes.

For instance, building on Faia and Monacelli (2007), Faia (2008) considers a general class of Taylor

rules, with strict inflation and exchange rate targeting as extremes, in a two-country sticky price model

with financial accelerator as in Bernanke et al. (1999). Using the welfare rankings that ignore the effect of

volatilities on mean welfare, she finds that the presence of credit frictions strengthens the case for floating

exchange rate regimes in economies facing external shocks.

A related line of papers consider a small open economy model with a similar financial frictions block

and foreign denomination of debt. Gertler et al. (2007) find that a fixed exchange regime exacerbates the

contraction caused by an adverse risk premium shock. According to Devereux et al. (2006), financial frictions

magnify volatility but do not affect the ranking of alternative policy rules. Finally, Elekdag and Tchakarov

(2007) show that at a certain level of leverage the peg starts to dominate the float if shocks originate abroad.

The aim of this paper is to fill the gaps in the literature by providing a qualitative and quantitative

characterization of the optimal monetary policy conduct in an open economy facing financial frictions. To

this end, we consider a medium-size two-country New Keynesian DSGE model with producer currency

pricing, augmented by the financial accelerator mechanism. Having defined the optimal policy as a Ramsey

cooperative equilibrium, we show how it is affected by fixing the exchange rate and how its outcomes deviate

from those obtained for a set of standard simple targeting rules. Contrary to the existing literature, focusing

on very simple models, we discuss how financial market imperfections interact with such frictions as the

presence of nontradable goods and wage stickiness. We argue that a more complex model is a necessary step

forward as the policy implications are sensitive to the types of frictions and, though to lesser extent, to the

type of shocks. At the same time, to build intuition for the main results, our strategy is to start with a

simple New Keynesian framework with capital accumulation and then build it up towards its fully-fledged

version, explaining the impact of each extension for the policy prescriptions.

Our main results can be summarized as follows. First, we find that if credit markets do not work perfectly,

strict PPI targeting leads to overexpansion (overcontraction) in economic activity in response to positive (neg-

ative) productivity shocks. The related welfare losses are non-negligible, especially if financial imperfections

interact with such frictions as nontradable production and wage stickiness. Second, monetary policy should

try to offset the effects of balance sheet shocks, thus allowing for deviations from price stability. Third,

foreign currency debt denomination affects the optimal monetary policy: it should be less contractionary in

response to positive domestic productivity disturbances and more so if productivity shocks originate abroad.

Fourth, financial frictions substantially decrease attractiveness not only of PPI targeting, but also of other

price targeting regimes. In contrast, they do not have a significant effect on the performance of a monetary

union agreement. Fifth, while credit frictions make nominal wage targeting deviate from the optimal policy

more than in the perfect financial markets case, it can be considered robust compared to other standard

simple policies.1

The paper proceeds as follows. Section 2 lays out the structure of our model. Section 3 discusses its

calibration. The welfare-based framework for evaluating alternative policies is presented in section 4. Section

5 discusses our main results. Section 6 concludes.

1 This last result can be seen as complementing the findings of Levin et al. (2005), who document a remarkable robustness

of a simple wage stabilization rule to model uncertainty.

2

2 Structure of the model

There are two countries in the world: Home (H) and Foreign (F ). Each country is inhabited by a continuum of

infinite-lived households, who consume a homogeneous consumption good and supply labour to a continuum

of firms. A perfectly competitive sector of capital producers combines the existing capital with investment

flows to produce the installed capital stock. Capital is managed and rented to firms by a continuum of

entrepreneurs, who use their net worth and a bank loan to finance the capital expenditures. Productivity

of each entrepreneur is subject to an idiosyncratic shock, not observed by the bank. This creates agency

problems and so interest charged by the banking sector is subject to a premium over the risk-free rate paid

by banks on households’ deposits.

There are two types of firms in each economy, each using capital and labour as inputs. Nontradable goods

producers sell their output only domestically, while tradable goods firms produce both for the local market

and for exports. Prices are denominated in the producer currency and set in a monopolistically competitive

fashion. Nontradable and tradable goods produced at home are combined with goods imported from abroad

into final consumption and investment goods in a perfectly competitive environment.

Fiscal authorities finance their expenditures on nontradable goods by collecting lump sum taxes from the

households.

Since the general setup of the Foreign country is similar to that for the Home economy, in the following

and more detailed exposition we focus on the latter. To the extent needed, variables and parameters referring

to foreign agents are marked with an asterisk. Unless stated otherwise, all variables in the derivations below

are expressed in per capita terms. Whenever aggregation across countries is needed, we make use of the

normalization of the world population to one, so that the size of Home is n and that of Foreign is 1 − n.

2.1 Households

Households in a given country are assumed to be homogenous, i.e. they have the same preferences and endow-

ments. Each household has access to complete markets for state-contingent claims, traded domestically and

providing insurance against individual (but not aggregate) income risk. This implies that any idiosyncratic

shocks among the households do not result in heterogeneity of their behaviour. Hence, we can focus on the

optimization problem of a representative household.

A typical household maximizes the following lifetime utility function:

(∞ ¸)

X · εd,t+k κ 1+ϕ

k 1−σ

Ut = Et β C − L (1)

1 − σ t+k 1 + ϕ t+k

k=0

**where Et is the expectation operator conditional on information available at time t, β is the discount
**

rate, σ is the inverse of the elasticity of intertemporal substitution, κ is the weight of leasure in utility and

ϕ denotes the inverse of the Frisch elasticity of labour supply. The instantaneous utility is thus a function

of a consumption bundle Ct , to be defined below, and labour effort Lt . The utility is also affected by a

consumption preference shock εd,t , common to all households in a given country.

The maximization of (1) is subject to a sequence of intertemporal budget constraints of the form:

PC,t Ct + Rt−1 Dt+1 + Rt−1 Bt+1 = Wt Lt + RK,t Kt + DivH,t + DivN,t + Tt + T RE,t + Dt + Bt (2)

**where PC,t is the price of the consumption bundle Ct , Wt is the nominal wage rate, RK,t denotes house-
**

holds’ income from renting a unit of capital Kt , DivH,t and DivN,t are dividends from tradable and non-

tradable goods producers, respectively, Tt stands for lump sum government transfers net of lump sum taxes

and T RE,t denotes wealth received from exiting (net of transfers to surviving and entering) entrepreneurs.

Households hold their financial wealth in form of bank deposits Dt , paying the risk-free (gross) rate Rt . As

in Chari et al. (2002), we assume complete markets for state-contingent claims. This means that households

have also access to state-contingent bonds Bt , paying the expected gross rate of return Rt .

3

2.1.1 Consumption choice

The first order conditions to the representative consumer maximization problem imply the following conven-

tional stochastic Euler equation:

½ ¾

λC,t+1 Rt

βEt =1 (3)

λC,t ΠC,t+1

where ΠC,t denotes CPI inflation (expressed in gross terms) and λC,t is the marginal utility of consumption,

defined as:

λC,t = εd,t Ct−σ (4)

The consumption bundle Ct consists of final tradable goods CT,t and nontradable goods CN,t , aggregated

according to:

γc 1−γc

CT,t CN,t

Ct = (5)

γcγc (1 − γc )1−γc

where γc is the share of tradable goods in total consumption.

The index of tradable goods is defined by:

α 1−α

CH,t CF,t

CT,t = (6)

αα (1 − α)1−α

where CH,t is the bundle of home-made tradable goods consumed at home, CF,t is the bundle of foreign-

made tradable goods consumed at home and α denotes the share of home goods in the home basket of

tradable goods.

The indices of nontradable and both types of tradable goods are in turn given by the following aggregators

of individual varieties:

·Z 1 φN −1

¸ φφN−1

N

CN,t = Ct (zN ) φN

dzN (7)

0

·Z 1 φH −1

¸ φφH−1

H

CH,t = Ct (zH ) φH

dzH (8)

0

·Z 1 φF −1

¸ φφF−1

F

CF,t = Ct (zF ) φF

dzF (9)

0

**where φN , φH , and φF are the elasticities of substitution across varieties of a given type.
**

The sequence of intratemporal optimization problems implies the following demand functions for each

variety of goods:

µ ¶−φN µ ¶−1

Pt (zN ) PN,t

Ct (zN ) = (1 − γc ) Ct (10)

PN,t PC,t

µ ¶−φH µ ¶−1 µ ¶−1

Pt (zH ) PH,t PT,t

Ct (zH ) = γc α Ct (11)

PH,t PT,t PC,t

µ ¶−φF µ ¶−1 µ ¶−1

Pt (zF ) PF,t PT,t

Ct (zF ) = γc (1 − α) Ct (12)

PF,t PT,t PC,t

where Pt (zj ) is the price of variety zj , while the composite price indexes are defined as follows:

·Z 1 ¸ 1−φ

1

N

PN,t = Pt (zN )1−φN dzN (13)

0

4

·Z 1 ¸ 1−φ

1

H

1−φH

PH,t = Pt (zH ) dzH (14)

0

·Z 1 ¸ 1−φ

1

F

1−φF

PF,t = Pt (zF ) dzF (15)

0

α 1−α

PT,t = PH,t PF,t (16)

γc 1−γc

PC,t = PT,t PN,t (17)

2.1.2 Wage setting

Each household j supplies monopolistically one distinctive type of labour Lt (j), which is aggregated with

labour services of other households in a given country into a homogenous labour input according to the

formula:

·Z 1 φW −1

¸ φφW−1

W

Lt = Lt (j) φW

dj (18)

0

**We follow Erceg et al. (2000) and assume that only a fraction 1 − θW of households can renegotiate
**

their wage contracts in each period, while wages of the remaining households are indexed to the steady-state

consumer price (CPI) inflation.

Households that are allowed to reset their wages take into account that they may not be allowed to do so

for some time, so they solve the following maximization problem:

(∞ · ¸)

X κ Wt (j) k

k k 1+ϕ

Et θW β − Lt+k (j) + λC,t+k Π̄ Lt+k (j) (19)

1+ϕ PC,t+k C

k=0

**subject to the sequence of labour demand constraints:
**

· ¸−φW

Wt (j) k

Lt+k (j) = Π̄ Lt+k (20)

Wt+k C

where the aggregate wage index is given by:

·Z 1 ¸ 1−φ1

W

1−φW

Wt = Wt (j) dj (21)

0

**The first-order condition associated with the optimization problem (19) can be written as:
**

(∞ · ¸ )

X W t (j) φW

k

Et θW βk Π̄k − M RSt+k (j) λC,t+k Lt+k (j) = 0 (22)

PC,t+k C φW − 1

k=0

where M RSt is the marginal rate of substitution between consumption and labour defined as:

κLt (j)ϕ

M RSt (j) = (23)

λC,t

Since all households that can renegotiate their wage contracts face an identical optimization problem,

they set the same optimal wage W̃t , which allows us to rewrite the first-order condition (22) in a recursive

way as:

Ã !1+ϕφW

W̃t φW ΦW,t

= (24)

PC,t φW − 1 ΨW,t

5

where the auxiliary state variables ΦW,t and ΨW,t are defined as:

µ ¶φW (1+ϕ) (µ ¶φ (1+ϕ) )

Wt 1+ϕ ΠC,t+1 W

ΦW,t = κ Lt + βθW Et ΦW,t+1 (25)

PC,t Π̄C

µ ¶φW (µ ¶φ −1 )

Wt ΠC,t+1 W

ΨW,t = λC,t Lt + βθW Et ΨW,t+1 (26)

PC,t Π̄C

Given the wage setting scheme described above, the aggregate wage index evolves according to the fol-

lowing formula:

h ¡ ¢1−φW i 1−φ1

Wt = θW Wt−1 Π̄C + (1 − θW )W̃t1−φW W

(27)

2.2 Capital producers

There is a continuum of perfectly competitive capital producers, owned by the households. At the end of each

period, they buy capital from entrepreneurs and combine it with investment goods to produce new installed

capital, which is then sold to entrepreneurs.

Consistently with the market clearing on the capital market, the total amount of capital purchased by

capital producers must be equal to total undepreciated capital stock in the economy. The economy-wide

capital available for production Kt+1 evolves then according to the formula:

Kt+1 = (1 − τ )Kt + εi,t (1 − ΓI,t ) It (28)

where It is investment and τ is the depreciation rate. As in Christiano et al. (2005), capital accumulation

is subject to investment-specific technological progress εi,t and adjustment cost represented by a function

ΓI,t , defined as:

µ ¶2

ςI It

ΓI,t = −1 (29)

2 It−1

The optimization problem of a representative capital producer is to maximize the present discounted

value of future profits:

( ∞

)

X λC,t+k

Et βk [QT,t+k PC,t+k ((1 − τ )Kt+k + εi,t+k (1 − ΓI,t+k ) It+k − Kt+k ) − PI,t+k It+k ] (30)

PC,t+k

k=0

**where PI,t is the price of investment goods It and QT,t is the real price of installed capital (Tobin’s Q).
**

The first order condition to this optimization problem yields the following investment demand equation:

½ 2 ¾

PI,t ¡ 0

¢ λC,t+1 It+1 0

= εi,t 1 − ΓI,t − It ΓI,t QT,t + βEt εi,t+1 Γ QT,t+1 (31)

PC,t λC,t It I,t+1

The final investment good is produced in a similar fashion as the final consumption good, which implies

the following definitions:

γI 1−γI

IT,t IN,t

It = (32)

γiγi (1 − γi )1−γI

α 1−α

IH,t IF,t

IT,t = (33)

αα (1 − α)1−α

γi 1−γi

PI,t = PT,t PN,t (34)

Hence, while we allow for differences in the tradable-nontradable composition between the final consump-

tion basket and the investment basket (i.e. γc need not be equal to γi ), we assume for simplicity that the

structure of the purely tradable component is identical for both types of goods.

6

2.3 Entrepreneurs and banks

Capital services to firms are supplied by a continuum of risk-neutral entrepreneurs, indexed by zE . At the

end of period t, each entrepreneur purchases installed capital Kt+1 (zE ) from capital producers, partly using

its own financial wealth Nt+1 (zE ) and financing the remainder by a bank loan BE,t+1 (zE ):

BE,t+1 (zE ) = QT,t PC,t Kt+1 (zE ) − Nt+1 (zE ) ≥ 0 (35)

After the purchase, each entrepreneur experiences an idiosyncratic productivity shock, which converts its

capital to aE (zE )Kt+1 (zE ), where aE is a random variable, distributed independently over time and across

entrepreneurs, with a cumulative density function F (aE ) and a unit mean. Following Christiano et al. (2003),

we assume that this distribution is log normal, with a time-varying standard deviation of log aE equal to

εe,t σE , known to entrepreneurs before their capital decisions.

Next, each entrepreneur rents out capital services, treating the rental rate RK,t+1 as given. Since the

mean of an idiosyncratic shock is equal to one, the average rate of return on capital earned by entrepreneurs

can be written as:

RK,t+1 + (1 − τ )QT,t+1 PC,t+1

RE,t+1 = (36)

QT,t PC,t

and the rate of return earned by an individual entrepreneur is aE (zE )RE,t+1 .

Idiosyncratic shocks are observed by entrepreneurs but not by banks, so lending involves agency costs,

reflected in a debt contract between these two parties. The contract specifies the size of the loan BE,t+1 (zE )

and the gross non-default interest rate RB,t+1 (zE ) charged by the bank. The solvency criterion can also

be defined in terms of a cutoff value of idiosyncratic productivity, denoted as ãE,t+1 (zE ), such that the

entrepreneur has just enough resources to repay the loan:2

ãE,t+1 RE,t+1 QT,t PC,t Kt+1 (zE ) = RB,t+1 BE,t+1 (zE ) (37)

Entrepreneurs with aE below the threshold level go bankrupt. Their all resources are taken over by the

banks, after they pay proportional and nontradable monitoring costs µ.

Banks finance their loans by issuing time deposits to households at the risk-free interest rate Rt . The

banking sector is assumed to be perfectly competitive and owned by risk-averse households. This together

with risk-neutrality of entrepreneurs implies a financial contract insulating the lender from any aggregate

risk.3 Hence, interest paid on a bank loan by entrepreneurs is state contingent and guarantees that banks

break even in every period. The aggregate zero profit condition for the banking sector can be written as:

(1 − F1,t+1 ) RB,t+1 BE,t+1 + (1 − µ) F2,t+1 RE,t+1 QT,t PC,t Kt+1 = Rt BE,t+1 (38)

or equivalently (using (37)):

RE,t+1 QT,t PC,t Kt+1 [ãE,t+1 (1 − F1,t+1 ) + (1 − µ) F2,t+1 ] = Rt BE,t+1 (39)

where

Z ãE,t

F1,t = dF (aE ) (40)

0

Z ãE,t

F2,t = aE dF (aE ) (41)

0

and the analytical formulas for F1,t and F2,t , making use of the log-normal assumption for F (aE ), are

given in the appendix.

The equilibrium debt contract maximizes welfare of each individual entrepreneur. We define it in terms

of expected end-of-contract net worth relative to the risk-free alternative, which is holding a domestic bond:

2 In order to save on notation, in what follows we use the result established later on, according to which the cutoff productivity

**ãE (zE ) and the non-default interest paid on a bank loan RB,t+1 (zE ) is identical across entrepreneurs.
**

3 Given the infinite number of entrepreneurs, the risk arising from idiosyncratic shocks is fully diversifiable.

7

(R ∞ )

ãE,t

(RE,t+1 QT,t PC,t Kt+1 (zE )aE (zE ) − RB,t+1 BE,t+1 (zE ))

Et (42)

Rt Nt+1 (zE )

The first-order condition to this optimization problem can be written as:

( RE,t+1 )

Rt [1³− ãE,t+1 (1 − F1,t+1 ) − F2,t+1 ] + ´

Et 1−F RE,t+1 =0 (43)

+ 1−F1,t+1 −µã1,t+1

E,t+1 F

0 Rt [ãE,t+1 (1 − F1,t+1 ) + (1 − µ) F2,t+1 ] − 1

1,t+1

**As can be seen from (43), the ex ante external financing premium arises because of monitoring costs: if µ
**

is set to zero, the expected rate of return on capital is equal to the risk-free interest rate and so the financial

markets are perfect.

Equation (43), together with the bank zero profit constraint (39) defines the optimal debt contract in

terms of the cutoff value of the idiosyncratic shock ãE,t+1 and the leverage ratio %t , defined as:

QT,t PC,t Kt+1

%t = (44)

Nt+1

It is easy to verify that these two contract parameters are identical across entrepreneurs. There are

two important implications of this result, facilitating aggregation. First, the loan amount taken by each

entrepreneur is proportional to his net worth. Second, the rate of interest paid to the bank is the same for

each non-defaulting entrepreneur:

ãE,t+1 RE,t+1 %t

RB,t+1 = (45)

%t − 1

Proceeds from selling capital, net of interest paid to the bank, constitute end of period net worth. To

capture the phenomenon of ongoing entries and exits of firms and to ensure that entrepreneurs do not

accumulate enough wealth to become fully self-financing, we assume that each period a randomly selected

and time-varying fraction 1 − εν,t υ of them go out of business, in which case all their financial wealth is

rebated to the households. At the same time, an equal number of new entrepreneurs enters, so that the

total number of entrepreneurs is constant. Those who survive and enter receive a transfer TE,t from the

households. This ensures that both entrants and surviving bankrupt entrepreneurs have at least a small but

positive amount of wealth, without which they would not be able to buy any capital.

Aggregating across all entrepreneurs and using (39) yields the following law of motion for net worth in

the economy:

· µ ¶ ¸

µF2,t RE,t QT,t−1 PC,t−1 Kt

Nt+1 = εν,t υ RE,t QT,t−1 PC,t−1 Kt − Rt−1 + BE,t + TE,t (46)

BE,t

The term in the square brackets represents the total revenue from renting and selling capital net of interest

paid on bank loans, averaged over both bankrupt and non-bankrupt entrepreneurs. The second term in the

round brackets is the expected excess cost of borrowing from the bank over the risk-free rate, and so can be

interpreted as the ex post external finance premium.

While discussing our results, we also consider a situation in which bank loans taken by entrepreneurs in

the home country are denominated in foreign rather than domestic currency. The modifications needed to

implement this variant are presented in the appendix.

2.4 Firms

2.4.1 Production technology

There exist a continuum of identically monopolistic competitive firms in each of the nontradable and trad-

able sectors, owned by households and indexed by zN and zH , respectively. The production technology is

homogenous with respect to labour and capital inputs:

Yt (zN ) = εn,t Lt (zN )1−ηN Kt (zN )ηN (47)

8

Yt (zH ) = εt,t Lt (zH )1−ηH Kt (zH )ηH (48)

where ηN and ηH are sector-specific output elasticities with respect to capital input, while εn,t and εt,t

are sector-specific productivity parameters. The output indexes are given by the Dixit-Stiglitz aggregators:

·Z 1 φN −1

¸ φφN−1

N

YN,t = Yt (zN ) φN

dzN (49)

0

·Z 1 φH −1

¸ φφH−1

H

YH,t = Yt (zH ) φH

dzH (50)

0

Since all firms in a given sector operate technologies with the same relative intensity of productive factors

and face the same prices for labour and capital inputs (factor markets are homogeneous), cost minimization

implies the following sector-specific capital-labour relationships:

Wt LN,t 1 − ηN Wt LH,t 1 − ηH

= = (51)

RK,t KN,t ηN RK,t KH,t ηH

2.4.2 Price setting

Firms producing nontradable goods set their prices according to the Calvo (1983) staggering mechanism.

Only a fraction 1 − θN of them set their prices in a forward-looking manner, while the prices of firms that

do not receive a price signal are fully indexed to the steady-state inflation in the nontradable sector Π̄N .

Firms that are allowed to reoptimize realize that they may not be allowed to do so for some time, hence

their price-setting problem is to maximize the expected present discounted value of future profits:

(∞ )

X £ ¤

k k λC,t+k k

Et θN β Yt+k (zN ) Pt (zN )Π̄N − PN,t+k M CN,t+k (52)

PC,t+k

k=0

**subject to the sequence of demand constraints:
**

· ¸−φN

Pt (zN ) k

Yt+k (zN ) = Π̄ YN,t+k (53)

PN,t+k N

where M CN,t is the real marginal cost (identical across nontradable goods firms) defined as:

µ ¶1−ηN µ ¶ηN

1 Wt RK,t

M CN,t = (54)

PN,t εn,t 1 − ηN ηN

The first-order condition associated with the profit-maximization problem faced by reoptimizing firms

can be written as:

(∞ · ¸ )

X

k k λC,t+k k φN

Et θN β Yt+k (zN ) Pt (zN )Π̄N − PN,t+k M CN,t+k = 0 (55)

PC,t+k φN − 1

k=0

There are no firm-specific shocks in the model, so all firms that are allowed to reset their price in a forward-

looking manner select the same optimal price P̃N,t , which implies the following recursive representation of

the first-order condition (55):

P̃N,t φN ΦN,t

= (56)

PN,t φN − 1 ΨN,t

where (µ ¶φN )

λC,t ΠN,t+1

ΦN,t = M CN,t PN,t YN,t + βθN Et ΦN,t+1 (57)

PC,t Π̄N

9

(µ ¶φN −1 )

λC,t ΠN,t+1

ΨN,t = PN,t YN,t + βθN Et ΨN,t+1 (58)

PC,t Π̄N

The expression for the evolution of the home nontradable goods price index can be written as follows:

h ¡ ¢1−φN i 1

1−φN 1−φN

PN,t = θN PN,t−1 Π̄N + (1 − θN )P̃N,t (59)

The price-setting problem solved by firms producing tradable goods is similar and leads to first-order

conditions and price indices analogous to equation (55) and (59), respectively. We assume that prices are

set in the producer currency and that the international law of one price holds for each tradable variety.

Therefore, the price of home goods sold abroad and that of foreign goods sold domestically are given by:

**Pt∗ (zH ) = ERt−1 Pt (zH ) Pt (zF ) = ERt Pt∗ (zF ) (60)
**

where ERt is the nominal exchange rate expressed as units of domestic currency per one unit of foreign

currency.

**2.5 Exchange rate dynamics
**

The perfect risk sharing condition implies (see Chari et al., 2002):

λ∗C,t

= Qt (61)

λC,t

where Qt is the real exchange rate defined as:

∗

ERt PC,t

Qt = (62)

PC,t

The real exchange rate is allowed to deviate from the purchasing power parity (PPP) due to changes in

relative prices of tradable vs. nontradable goods in both countries (the internal exchange rates) and changes

in terms-of-trade, as long as there is some home bias in preferences (α 6= α∗ ). This can be demonstrated

using the price indices derived above and the law of one price conditions for tradable goods:

∗1−γ ∗

∗ Xt c

Qt = Stα−α 1−γc (63)

Xt

where the terms-of-trade St is defined as home import prices relative to home export prices:

∗

ERt PF,t

St = (64)

PH,t

and the internal exchange rates Xt and Xt∗ are defined as:

∗

PN,t PN,t

Xt = Xt∗ = ∗ (65)

PT,t PT,t

**2.6 Monetary and fiscal authorities
**

We consider several variants of monetary policy regimes, including the Ramsey optimal policy. For calibration,

we assume that the monetary authority responds to the economic conditions through the following interest-

rate feedback rule:

" µ ¶φ µ ¶φdy µ ¶φdπ #1−ρ

ρ ΠC,t π Yt ΠC,t

Rt = Rt−1 R̄ εm,t (66)

Π̄C Yt−1 ΠC,t−1

10

where Yt is total output, Ȳ is its steady state level, R̄ is the steady state interest rate and εm,t is a

monetary policy shock.

The fiscal authority is modelled in a very simplistic fashion: government expenditures and transfers to

the households are fully financed by lump sum taxes, so that the state budget is balanced each period. The

government spending is fully directed at nontradable goods and is modelled as a stochastic process εg,t . Given

our representative agent assumption, Ricardian equivalence holds in the model.

**2.7 Market clearing conditions
**

2.7.1 Goods markets

The model is closed by imposing the following market clearing conditions. Output of each firm producing

non-tradable goods is either consumed domestically, spent on investment, purchased by the government or

used by banks to cover monitoring costs. Similarly, all tradable goods are consumed or invested domestically

or abroad. Using these conditions, the demand functions (10), (11) and (12) together with their analogs for

investment and government goods, the output indexes given by (49) and (50), and taking into account the

size of both countries, one can write the aggregate output in the two sectors at home as:

PC,t PI,t

YN,t = (1 − γc ) Ct + (1 − γi ) It + Gt + (67)

PN,t PN,t

−1

+µF2,t RE,t QT,t−1 PC,t−1 Kt PN,t

∗

PC,t 1 − n ∗ ∗ PC,t

YH,t = αγc Ct + α γc ∗ Ct∗ + (68)

PH,t n PH,t

∗

PI,t 1 − n ∗ ∗ PI,t

+αγi It + α γi ∗ It∗

PH,t n PH,t

Total output Yt is the sum of output produced in the nontradable and tradable sectors:

Yt = YN,t + YH,t (69)

or in nominal terms:

Pt Yt = PN,t YN,t + PH,t YH,t (70)

where Pt is the implicit total output deflator. We use these definitions to construct the overall producer

price index (PPI) inflation as a weighted average of inflation in both sectors, with weights consistent with

the Laspeyres concept:

PN,t−1 YN,t−1 PH,t−1 YH,t−1

Πt = ΠN,t + ΠH,t (71)

Pt−1 Yt−1 Pt−1 Yt−1

2.7.2 Factor markets

Equilibrium in factor markets requires:

Z 1 Z 1

Lt = Lt (zN )dzN + Lt (zH )dzH (72)

0 0

Z 1 Z 1

Kt = Kt (zN )dzN + Kt (zH )dzH (73)

0 0

which can be rewritten using (47), (48), (51) and the demand sequences like in (53) as:

11

µ ¶η µ ¶η µ ¶η ¶ηH µ

1 − ηN N RK,t N YN,t 1 − ηH RK,t H YH,t

Lt = ∆N,t + ∆H,t (74)

ηN Wt εn,t ηH Wt εt,t

µ ¶1−ηN µ ¶1−ηN µ ¶1−ηH µ ¶1−ηH

ηN Wt YN,t ηH Wt YH,t

Kt = ∆N,t + ∆H,t (75)

1 − ηN RK,t εn,t 1 − ηH RK,t εt,t

where ∆N,t and ∆H,t are the measures of price dispersion in the nontradable and tradable sector:

Z 1 µ ¶−φN Z 1 µ ¶−φH

PN,t (zN ) PH,t (zH )

∆N,t = dzN ∆H,t = dzH (76)

0 PN,t 0 PH,t

The following laws of motion for the two dispersion indexes can be derived using (59):

Ã !−φN µ ¶−φN

P̃N,t Π̄N

∆N,t = (1 − θN ) + θN ∆N,t−1 (77)

PN,t ΠN,t

Ã !−φH µ ¶−φH

P̃H,t Π̄H

∆H,t = (1 − θH ) + θH ∆H,t−1 (78)

PH,t ΠH,t

2.7.3 Financial markets

Finally, in equilibrium, household deposits at banks must be equal to total funds lent to entrepreneurs:

Dt = BE,t (79)

2.8 Exogenous shocks

There are eight stochastic disturbances hitting each economy. These concern: productivity in the tradable

sector, productivity in the nontradable sector, consumption preferences, government spending, investment-

specific technology, survival of entrepreneurs, idiosyncratic riskiness and the monetary policy. The log of

each shock follows a linear first-order autoregressive process, except for the monetary policy shock, which is

assumed to be white noise.

3 Calibration

We calibrate our model to the euro area economy, setting its size in our two-country world to 0.25. The

parameters for the rest of the world are assumed to be identical to those in the euro area. Our calibration

proceeds in two steps. We first match the key steady-state ratios and set the other structural parameters so

that they are consistent with the estimated version of the New Area-Wide Model (NAWM), documented in

Christoffel et al. (2008). Parameterization of the financial frictions block is based on Bernanke et al. (1999)

and Christiano et al. (2007). In the next step, the inertia and volatility of stochastic disturbances are chosen

to match the moments of a standard set of euro area macroaggregates, augmented by two financial variables.

These are the debt of the enterprise sector and the spread between loans to firms and the risk-free rate. The

results of the calibration exercise are reported in Tables 1 to 4 and the resulting variance decomposition is

shown in Table 5.

**Tables 1 to 5 about here
**

Our model replicates the standard deviations of GDP and its main components. It significantly underes-

timates the volatility of the short-term interest rate and roughly captures that of inflation. As regards our

two financial variables, there is a trade-off in matching the standard deviation of entrepreneurs’ debt and

that of the external financing premium. We chose to keep the former somewhat lower than observed in the

data, and the latter much higher. This choice is motivated by the fact that there may be some measurement

problems with the euro-wide data as the volatility of the corporate credit premium is an order of magnitude

12

smaller than that found in the US.4 Turning to other moment matching results, our model gets persistence

and cyclical behaviour of most of the variables of interest more or less right, although the fit for investment

can be seen as disappointing, given the model’s focus on frictions in financing capital expenditures. It is

also worth noting that while our model makes the premium less countercyclical than in the data, it some-

what exaggerates its negative correlation with investment. Clearly, better fit in this dimension would require

allowing for financial frictions also in the household sector.

**4 Welfare-based evaluation of alternative policies
**

In our framework, a natural welfare criterion is the discounted sum of expected utility flows given by (1),

averaged over all households:

∞

X · Z 1 ¸

k εd,t+k 1−σ κ

Ut = Et β C − Lt+k (j)1+ϕ dj (80)

1 − σ t+k 0 1+ϕ

k=0

**Using a general form of labour demand sequences (20), our welfare criterion can be rewritten in a recursive
**

form:

εd,t 1−σ κ

Ut = C − ∆W,t L1+ϕ + βEt {Ut+1 } (81)

1−σ t 1+ϕ t

**where the wage dispersion index ∆W,t is defined as:
**

Z 1 µ ¶−φW (1+ϕ)

Wt (j)

∆W,t = dj (82)

0 Wt

and (using (27)) subject to the following law of motion:

Ã !−φW (1+ϕ) µ ¶−φW (1+ϕ)

W̃t Π̄C Wt−1

∆W,t = (1 − θW ) + θW ∆W,t−1 (83)

Wt Wt

**It is clear from (81) that in our model welfare depends positively on the level of consumption and negatively
**

on wage and price dispersion, with the latter relationship following from the market clearing condition for

the aggregate labour input (74).

We define the optimal policy in our model as the Ramsey cooperative equilibrium, in which both cen-

tral banks implement policies that maximize the weighted average of welfare (as defined above) of the two

regions, with the weights given by the population size.5 As in Woodford (2003), we consider policies under

commitment in a timeless perspective. Under these restrictions, our benchmark generates the best possible

allocation in our two-region world. In principle, there is no guarantee that this policy maximizes welfare of a

representative consumer in each region. Coenen et al. (2008) show that the Nash equilibrium, in which each

central bank maximizes welfare of its own country taking as given the other central bank’s action, might yield

higher welfare from an individual country’s perspective so that the gains from cooperation are negative. We

leave this more complex6 analysis of non-cooperative policies for future research and will refer henceforth to

the cooperative equilibrium as optimal.

In order to build intuition for the optimal policy outcomes, we compare them to those obtained under

simple policy variants. These include various forms of strict inflation targeting and, following the findings in

Levin et al. (2005), nominal wage targeting. We also consider the case of a full monetary integration, defined

as the same cooperative equilibrium of the benchmark case, except that the exchange rate between the two

regions is fixed.

4 For instance, Gilchrist et al. (2009) estimate the standard deviation of credit spreads in the US at about 300 bps., compared

**to 43 bps. in our euro area data.
**

5 The first order conditions of the welfare maximization problem of the policy maker(s) are computed using G. Lombardo’s

**lq solution routine, downloadable from http://home.arcor.de/calomba.
**

6 As it is well known, the Nash equilibrium depends on the choice of instrument defining the policy game and the concept of

equilibrium (open loop vs. closed loop).

13

We assess the welfare implications of the alternative monetary policy strategies by taking a second-order

approximation of all model equations, including the first-order conditions of the welfare maximization problem

of the policy maker.7 Such a numerical approach yields a correct ranking of alternative policies and has been

used in many analyses of optimal policy (see e.g. Schmitt-Grohe and Uribe, 2006; Coenen et al., 2008).8

We evaluate each policy by calculating the welfare loss, expressed in terms of the proportion of each

period’s consumption that the typical household in the home economy would need to give up in a deterministic

world so that its welfare is equal to the expected conditional utility in the stochastic world. More precisely,

we calculate Ω that satisfies the following equation:

∞ µ ¶ Ã ·µ ¶ ¸1−σ !

X εd,t+k 1−σ κ 1 1 Ω κ

Et βk C − ∆W,t+k L1+ϕ = 1− C − L1+ϕ (84)

1 − σ t+k 1+ϕ t+k

1−β 1−σ 100 1+ϕ

k=0

where variables without time subscripts denote their respective steady state values and the starting point

for the left hand side of (84) is the ergodic mean of the cooperative equilibrium.

5 Results

5.1 Optimal policy in a simple model with capital accumulation

Our main objective is to demonstrate how the presence of financial frictions changes the optimal policy

response. To make the exposition more transparent and comparable to the previous literature, we first

consider a simplified version of our model and then build it up, explaining the policy implications of each

addition. More specifically, our departure point is a perfectly symmetric two-country world with the following

features: perfect financial markets, flexible wages, only tradable goods, no home bias and no government

purchases. This special case can be easily obtained from the full specification described in section 2 by

setting a subset of parameters to appropriate values. In other words, we consider a standard two-country

New Keynesian model with capital accumulation and analyze how adding to it financial frictions changes the

optimal monetary policy.

Before we move on to the results, one remark is in order. Remember that we calibrate all parameters

(and shock volatilities in particular) using the fully-fledged version of our model. This means that its simple

variants do not necessarily retain a solid empirical basis if the parameters are kept unchanged. Therefore,

in order to facilitate comparisons, we normalize all welfare losses presented below by the ratio of output

variance in a given version (under the Taylor rule) to output variance in the full version of our model.9

Table 6 present the welfare losses (relative to the optimal cooperative policy) of a set of simple policies in

our benchmark model with perfect or imperfect financial markets. It is well known (see e.g. a recent review

by Engel, 2009) that in the standard open economy New Keynesian model with producer currency pricing,

PPI targeting replicates the optimal policy outcomes. As can be seen from Table 6, this is also the case

in the model with endogenous capital accumulation.10 The losses associated with keeping consumer prices

or the exchange rate stable are non-negligible but do not exceed 0.08% of steady-state consumption, while

the Taylor rule performs worst. These losses are almost entirely due to technology disturbances, while the

contribution of other shocks (preference and investment-specific in this simple model version) is very close to

zero.

**Table 6 about here
**

7 Thecalculations are performed in Dynare 4, which can be downloaded from http://www.cepremap.cnrs.fr/dynare.

8 Analternative would be to use a linear-quadratic approximation described in Benigno and Woodford (2005), which is a

generalization to Rotemberg and Woodford (1998). As discussed by Benigno and Woodford (2006), a clear advantage of this

analytical approach is that it helps to gain insight into fully optimal policy. However, given the size and complexity of our

model, following this way seems to be of little use, so we opt for a more practical and less time-consuming method.

9 This is motivated by the fact that welfare losses are approximately proportional to the variance of stochastic disturbances.

Therefore, our normalization can be thought of as a proportional correction of all shock volatilities so that the standard deviation

of output in a given model version matches that observed in the data.

10 As demonstrated by Edge (2003), the utility-based loss function of a policy maker in a standard New Keynesian model is

modified if one allows for endogenous capital accumulation. Our estimates show that the effects of this modification for optimal

policy prescriptions can be ignored in practice.

14

If financial markets are imperfect, PPI targeting is no longer optimal. The welfare loss associated with

this policy amounts to less than 0.05% of steady-state consumption. This number may appear rather small.

However, as Table 7 reveals, the consequences of introducing financial frictions turn out to be an order of

magnitude larger than those related to home bias, habits, nontradable goods or government expenditures.

One can also note that the presence of financial frictions makes the monetary union or the Taylor rule

relatively more attractive, while the opposite holds true for CPI targeting.

**Table 7 about here
**

In order to gain insight into an optimal monetary policy conduct when financial markets are imperfect,

we compare the impulse responses under the cooperative regime to those implied by PPI targeting. Figure

1 depicts the dynamic responses to a positive productivity shock in the home economy. If both central

banks target domestic producer prices, the shock is clearly expansionary, although there is a short-lived

contraction in foreign economy’s output. Since entrepreneurs’ balance sheets improve, the external finance

premium goes down, which leads to an acceleration of investment. No home bias in preferences implies that

the real exchange rate is constant (see equation (63)), so real interest rates in both countries must respond

symmetrically. However, nominal rates at home fall more than abroad, so the exchange rate depreciates.

Under the optimal cooperative regime, there is also an expansion in the economic activity, but it is more

moderate, especially on impact. To achieve this, both central banks actually tighten their policy before

letting the short-term real interest rates follow closely the path of PPI targeting. As a result, the decline

in the external financing premium of the home country is more than halved and its response abroad is even

slightly positive. The reason why the optimal policy attempts to dampen the movements in the risk premium

is that they act as a distortionary tax on investment, the excessive fluctuations of which are inefficient. In

other words, the policy maker faces a trade-off between the costs of price dispersion and inefficiencies related

to movements in the financing premium. It is also worth noting that the optimal policy delivers smaller

responses of the exchange rate and consumer price inflation in both countries.

**Figure 1 about here
**

As in the frictionless case, the welfare implications of other shocks (preference and investment-specific

shocks, as well as two shocks related to entrepreneurs, i.e. survival rate and riskiness) lumped together are

an order of magnitude smaller than those of productivity shocks. It is interesting to note, however, that in

this case the fixed exchange rate regime performs better than strict PPI targeting. This observation applies

for any of these shocks considered individually.

We take a closer look at a negative survival rate shock as this shock is sometimes argued to reflect net

worth destruction observed in the recent financial turmoil. The dynamic responses are shown in Figure 2. By

raising the external financing premium, this shock acts like a cost-push shock, so keeping prices stable requires

tightening of the monetary policy. The optimal response tries to strike a balance between the negative effects

of price dispersion and an inefficient rise in the external financing premium. As a result, central banks try

to offset net worth destruction resulting from the shock with an initial easing of the monetary policy, which

allows to dampen the response in the premium at the expense of a rise in inflation and large swings in the

nominal exchange rate. If both countries agree to fix their exchange rate, they come closer to the optimum

than under PPI targeting. The reason is that the union case allows for some increase in inflation and a

short-run expansion, which helps to limit an increase in the premium.

**Figure 2 about here
**

While the general prescriptions for the optimal policy facing financial frictions and net worth shocks

developed above are broadly consistent with the Carlstrom et al. (2009) analysis abstracting away from

capital accumulation, one remark is in order. In their model, optimal policy is expansionary in response to

a negative net worth shock in terms of cumulative real rates, but they actually increase on impact only to

decline below levels implied by price stability, so the initial rise of the risk premium is higher under optimal

policy. This results in a rather unintuitive conclusion that introducing risk premia will lead the central

bank to magnify their movements compared to the strict inflation targeting regime. The authors conjecture

that a more elaborate model, featuring demand-side effects via endogenous capital accumulation, is going to

15

preserve this result. In contrast, our model implies that the initial response of optimizing policy makers to

net worth destruction will be easing on impact, which we consider more realistic.

5.2 Debt denomination

In the simple model considered so far, the two economies were perfectly symmetric. In this section we revisit

the case when one of the country’s entrepreneurial debt is denominated in the other country’s currency. We

will refer to this case as debt euroization and contrast its welfare implications with the baseline variant, i.e.

domestic currency debt denomination. The results are reported in Table 8, which splits the shocks by their

origin.

**Table 8 about here
**

The most striking result is that if domestic entrepreneurs’ debt is denominated in the foreign currency,

PPI targeting nearly replicates the optimal response to home productivity shocks, while the other regimes

somewhat lose in attractiveness. In contrast, strict producer price inflation stability performs significantly

worse than CPI targeting, and even more so compared to the union case, if productivity shocks originate

abroad. On balance, if productivity volatility is equal in both economies, the welfare ranking of alternative

regimes remains intact compared to the non-euroized case. However, if productivity shocks abroad are on

average sufficiently larger than at home, then the euroized economy may find itself better-off having the

exchange rate fixed.

The intuition for this result is as follows. We have seen in our baseline variant that a positive productivity

shock at home leads to an expansion in economic activity and depreciation of the exchange rate, both under

the optimal policy and PPI targeting. If entrepreneurs’ debt is denominated in the foreign currency, however,

the depreciation has also an adverse effect on their balance sheets, which cools down the boom. This is

confirmed by the impulse responses presented in Figure 3. Comparing them to those shown in Figure 1 for

the case of domestic currency debt denomination reveals that the drop in the external financing premium is

now substantially smaller. Interestingly, this exchange rate related additional balance sheet channel implies

that the optimal policy no longer tightens on impact but rather lets the real interest rates fall, like under PPI

targeting. By construct, this channel does not operate if the exchange rate is fixed, so the responses for the

union case in the euroized and non-euroized cases are the same. Since keeping the exchange rate constant

requires initial tightening, the responses under this regime are now further away from the optimum.

**Figure 3 about here
**

An analogous reasoning can be used to see why PPI targeting deviates more from the optimal policy if

entrepreneurs’ debt is denominated in the foreign currency and productivity shocks originate abroad. Since

in this case the exchange rate appreciates, the balance sheets of entrepreneurs improve and so the economic

expansion at home is magnified. Therefore, as can be seen from Figure 4, the optimal policy now tightens

much more on impact and so moves further away from the easing policy required to stabilize PPI inflation.

With our parametrization, this effect is strong enough to make the fixed exchange rate a relatively more

attractive option.

**Figure 4 about here
**

More generally, the policy ranking obtained in the euroized case for foreign productivity shocks depends

on the extent of financial market imperfections and the size of leverage. If financial frictions are substantial

and entrepreneurs run sufficiently high debt denominated in the foreign currency, the balance sheet effects

related to exchange rate movements will be important and the fixed exchange rate regime will yield higher

welfare than PPI targeting. If on the other hand financial markets are close to perfect and leverage small,

stabilizing PPI inflation will be preferred. More detailed experiments reveal that our model parametrization

is quite close to this threshold: if about 55% or more of capital purchased by entrepreneurs is financed by

their net worth (compared to 50% in our baseline calibration), the welfare ranking of policies is the same as

in the non-euroized case.11

11 Alternative values of leverage were obtained by playing around with various combinations of parameters, but mainly with

the share of transfers received by entrepreneurs from the households.

16

5.3 Nontradable production

We next relax the assumption that all goods are tradable and consider a more general version of our model,

with the share of nontradable inputs in consumption and investment as in our baseline parametrization. The

welfare losses of alternative monetary regimes are reported in Table 9.

Our findings for a model with perfect capital markets are consistent with the previous literature. In

particular, PPI targeting no longer replicates the optimal policy, even though the losses are very small

in practice.12 Also, in line with Duarte and Obstfeld (2008), the presence of nontradable goods clearly

strengthens the case for exchange rate flexibility.

Adding financial frictions makes the losses from PPI targeting non-negligible. This effect is substantially

stronger than in a model where all goods are tradable. As before, the monetary union somewhat gains relative

to other regimes, but this time, at least under our parametrization, falls short of CPI targeting.

Taking a closer look at the decomposition of welfare losses by shocks when entrepreneurs’ debt is de-

nominated in the domestic currency, at least one observation warrants a comment. Contrary to the model

without nontradables, PPI targeting performs slightly worse than CPI targeting and substantially worse than

the monetary union in response to productivity shocks originating in the domestic tradable sector. However,

in this very case it is actually targeting PPI inflation in the nontradable sector that comes closest to the

optimal policy.

**Table 9 about here
**

In order to shed some light on why the policy ranking changes if we allow for nontradable production,

we use the impulse response analysis. Figure 5 shows the dynamic responses to a home tradable sector

productivity shock under various regimes. The outcomes under optimal policy are qualitatively very similar

to those obtained in the fully tradable version of our model presented in Figure 1. Compared to strict

PPI targeting, the optimal cooperative policy tries to dampen the boom fuelled by the financial accelerator

mechanism. Importantly, however, the difference between these two policies is now more pronounced in

relative terms. In particular, the optimal policy designs nearly twice lower depreciation and a three times

lower decrease in the external finance premium. The reason why PPI targeting overexpands relatively more

than we have seen in our simple model is that the presence of the nontradable sector makes stabilizing the

overall producer inflation more difficult. This is because nontradable goods prices are less flexible, which

follows from our calibration (see Table 1), but also from the fact that they are insulated from direct effects of

exchange rate movements.13 As a result, keeping PPI constant now requires more policy easing (in relative

terms, i.e. after correcting for the fact that an increase in productivity affects only one sector of the economy),

the side effect of which is an excessive decrease in external financing premium.

If the exchange rate is pegged, the effect of the financial accelerator is nearly eliminated and so the

economic expansion is dampened too much. However, the deviations from the optimal policy turn out to

be smaller than in the PPI targeting case, hence the union case ranks better. Targeting nontradable goods

prices comes closest to optimal and so outperforms all other simple regimes. It completely eliminates price

dispersion in the nontradable sector and lets the average level of producer prices drop. Hence, it does not

require as much easing as PPI targeting and so leads to a boom that is only slightly excessive.

**Figure 5 about here
**

Naturally, the ranking of regimes established for a model without nontradables remains valid in the

model with nontradable production as long as the share of the latter in output is sufficiently small. As

our experiments show, however, the union case dominates PPI targeting in response to foreign tradable

productivity shocks already when the share of nontradables is around 10%, so our finding about the change

in the policy ranking can be treated as robust.

If both some goods are nontradable and domestic entrepreneurs’ debt is denominated in the foreign

currency, our results are qualitatively similar to those obtained for the fully tradable and euroized case

12 Interestingly,if productivity shocks originate abroad, PPI targeting yields marginally higher welfare for the home economy

than the cooperative equilibrium. This means that in some cases implementing the cooperative policy might be problematic.

13 If the Calvo probabilities in the tradable and nontradable sectors are equal, monetary union still generates higher welfare in

response to a home tradable sector productivity shock than PPI targeting. Naturally, the difference between the performance

of these two regimes is then much smaller.

17

presented in Table 8. In particular, PPI targeting performs closest to optimal in response to domestic tradable

sector productivity shocks. This means that, under our parameterization, the presence of nontradables is not

enough to offset the stabilizing effect of euroized liabilities discussed in the previous section. In principle, this

result depends on the size of the nontradable sector. We find, however, that the fixed exchange rate regime

yields higher welfare than PPI targeting in response to domestic tradable sector productivity disturbances

in a euroized economy only if the share of nontradable production in total output is at least 80%, which is

more than observed in the data (see Lombardo and Ravenna, 2009).

Finally, we note that, as before, if shocks originate in the tradable sector abroad, PPI targeting performs

worse than CPI targeting and the union. However, these two rules are beaten by nontradable goods inflation

stabilization. More generally, while targeting nontradable sector prices seems to be an attractive alternative

to stabilizing the weighted average of inflation in both sectors whenever the latter policy performs worse than

the union case, it is not so in general. Taking all shocks into account, targeting PPI in the nontradable sector

is inferior to total PPI targeting.

**5.4 The role of wage stickiness
**

As the last step in our analysis, we extend the models discussed in the previous section for sticky wages. The

welfare losses of alternative monetary regimes are reported in Table 10.

In line with the studies using a simpler closed economy setup (see e.g. Erceg et al., 2000; Benigno and

Woodford, 2004), we find that adding wage stickiness to the frictionless version of our model makes strict

inflation stabilization policies clearly suboptimal. A particularly strong increase in welfare losses can be

observed for both variants of PPI targeting, which become inferior to CPI stabilization. On the contrary,

the performance of the fixed exchange rate and Taylor rules hardly change compared to the flexible wages

case. Both of these policies clearly dominate any of the price targeting regimes. Consistently with the results

obtained by Levine et al. (2005), the best performer is now nominal wage targeting.

When we relax the assumption on perfect financial markets, these findings become even more pronounced.

The welfare losses related to any of the three strict price stabilization policies increase by a factor of two or

more and can be considered very substantial. This can be contrasted with a very moderate change in the

performance of the monetary union and Taylor rules, particularly if entrepreneurs’ debt is denominated in

the foreign currency. Finally, even though the size of welfare losses associated with wage inflation targeting

increases by a factor of three or four, this policy remains superior to any of the alternatives considered.

**Table 10 about here
**

As before, we build intuition for our results by looking at how different shocks contribute to the welfare

losses discussed above, starting first with domestic currency debt denomination. It is clear from Table 10

that the large welfare losses of price stabilization strategies are mainly due to productivity shocks, while the

relative decrease in performance of the remaining regimes can be mainly, or in some cases even exclusively,

attributed to other shocks. We illustrate these results in Figures 6 to 10, plotting the impulse responses to

the main shocks of interest.

We have seen in the previous sections that strict PPI targeting required monetary policy easing that was

too excessive. Looking at Figure 6, showing the responses to a tradable sector productivity shock at home,

it is clear that now this effect is much stronger. This is because if wages are sticky, their contribution to

mitigate deflationary pressures caused by an increase in productivity is reduced for a given interest rate path.

Therefore, the monetary expansion needed to keep PPI inflation unchanged is bigger and the resulting boom

magnified by the financial accelerator. At the same time, fluctuations in nominal wages are now undesired

from the welfare perspective. This means that the optimal policy has an incentive to reduce them, so it is

actually more restrictive on impact compared to the model with flexible wages. As a result, PPI targeting

and the cooperative equilibrium deviate from each other more than before. Similar mechanisms deteriorate

the performance of CPI stabilization. This regime, however, is now superior to PPI targeting as it allows for

a fall in producer prices and so does not require so much monetary expansion. The remaining policies imply

significantly more moderate wage adjustment, hence the outcomes they yield do not differ that much from

those obtained under flexible wages. In particular, the dampening of economic expansion obtained with the

wage targeting regime turns out to be close to that designed by the optimal policy.

18

Figure 6 about here

Considerations analogous to those described above also help to understand the weak performance of price

stabilization regimes in response to home nontradable sector shocks (see Figure 7). This time, however, it is

nontradable sector inflation stabilization that leads to largest welfare losses as it requires very strong policy

easing to offset deflationary pressures in this sector.

**Figure 7 about here
**

If productivity shocks originate abroad, producer price stabilization policies in the home economy do not

require so much monetary expansion. However, the strong appreciation pressure caused by a large decrease

in interest rates abroad implies the need for excessive policy easing at home as well (see Figure 8 and 9).

Therefore, similarly to what we have seen for the shocks of a domestic origin, overall PPI targeting does

badly in response to tradable productivity shocks in the foreign economy, while nontradable PPI targeting

generates large welfare losses in response to foreign nontradable sector shocks. Contrary to producer price

stabilization, the relative attractiveness of CPI targeting declines significantly if productivity shocks come

from abroad. This is because, given deflationary pressures from the foreign economy, inflation needs to be

generated in domestic sectors to keep the price of a home consumption basket stable, which implies monetary

easing and an inefficiently large drop in the risk premium.

**Figure 8 and 9 about here
**

We note that while wage targeting outperforms all other simple regimes in response to productivity shocks

when wages are sticky and financial markets are imperfect, it is not always the case for other shocks. In

particular, fixing the exchange rate turns out to be a better option in response to a destruction in net worth.

Even though the implications of this disturbance for welfare evaluation are very small compared to produc-

tivity shocks, it might be instructive to examine the impulse responses to this shock under different regimes,

which we plot in Figure 10. Similarly to a model with flexible wages and no nontradable production (see

Figure 2), the optimal policy is expansionary following an unexpected decrease in net worth. A qualitatively

similar response is also possible if the exchange rate is fixed. In contrast, due to a cost-push nature of the

shock, a tightening is required to keep nominal wages (and even more so prices) constant.

**Figure 10 about here
**

Finally, we discuss how the results presented above are affected by denomination of entrepreneurs’ debt.

The most significant observation that can be taken from Table 10 is that debt euroization makes the two

PPI targeting regimes deviate less (more) from the optimal policy if productivity shocks originate at home

(abroad). This result can be understood by looking at the exchange rate movements presented for the non-

euroized case, using the intuition we have built for the simple model with flexible wages and tradable goods

only. It is clear from Figures 6 to 9 that PPI stabilization policies lead to depreciation of the exchange rate

for domestic productivity shocks, helping to dampen the boom and inefficient movements in the external

financing premia through an adverse effect on entrepreneurs’ balance sheets, while the opposite holds true

for shocks coming from abroad.

6 Conclusions

In this paper, we have analyzed and quantified how frictions in financing capital expenditures affect the

optimal monetary policy conduct in a two-country DSGE setup. Consistently with the earlier literature

using more simple and closed-economy models, we find that financial market imperfections generate a trade-off

between inflation and external financing premium stabilization, making strict inflation targeting suboptimal.

We show, however, that the welfare implications of this trade-off are non-negligible. In particular, financial

frictions substantially magnify the incentives to deviate from price stability created by such frictions if we

allow for nontradable goods and wage stickiness.

In contrast, financial market imperfections considered in our paper do not have a significant effect on the

performance of the monetary union. This means that the presence of financial frictions strengthens the case

19

for such an arrangement if cooperation between countries under flexible exchange rate regimes is difficult to

implement.

There is a number of potentially fruitful future research directions, of which we will name only two. First,

it might be interesting to revisit the literature on international monetary policy cooperation. According to

our preliminary (and not reported) calculations, gains from cooperation after introducing financial frictions

remain small, especially if mark-up shocks are absent. However, this may change if one allows for international

financial market integration, where firm balance sheets depend on foreign assets, as in Dedola and Lombardo

(2009). Second, some of the issues addressed in our paper, like debt euroization and monetary integration,

may be particularly relevant for small open economies. A realistic investigation of such cases would call

for an asymmetric setup, especially while constructing monetary policy games. We leave these interesting

extensions for future research.

References

Benigno, P., and M. Woodford (2004): “Optimal Stabilization Policy When Wages and Prices are Sticky:

The Case of a Distorted Steady State,” NBER Working Papers 10839, National Bureau of Economic

Research, Inc.

(2005): “Inflation Stabilization And Welfare: The Case Of A Distorted Steady State,” Journal of

the European Economic Association, 3(6), 1185–1236.

(2006): “Linear-Quadratic Approximation of Optimal Policy Problems,” NBER Working Papers

12672, National Bureau of Economic Research, Inc.

Bernanke, B. S., M. Gertler, and S. Gilchrist (1999): “The financial accelerator in a quantitative

business cycle framework,” in Handbook of Macroeconomics, ed. by J. B. Taylor, and M. Woodford, vol. 1

of Handbook of Macroeconomics, chap. 21, pp. 1341–1393. Elsevier.

Calvo, G. A. (1983): “Staggered prices in a utility-maximizing framework,” Journal of Monetary Eco-

nomics, 12(3), 383–398.

Carlstrom, C. T., T. S. Fuerst, and M. Paustian (2009): “Optimal Monetary Policy in a Model with

Agency Costs,” mimeo.

Chari, V. V., P. J. Kehoe, and E. R. McGrattan (2002): “Can Sticky Price Models Generate Volatile

and Persistent Real Exchange Rates?,” Review of Economic Studies, 69(3), 533–63.

Christiano, L. J., M. Eichenbaum, and C. L. Evans (2005): “Nominal Rigidities and the Dynamic

Effects of a Shock to Monetary Policy,” Journal of Political Economy, 113(1), 1–45.

Christiano, L. J., R. Motto, and M. Rostagno (2003): “The Great Depression and the Friedman-

Schwartz hypothesis,” Proceedings, pp. 1119–1215.

(2007): “Financial Factors in Business Cycles,” mimeo.

Christiano, L. J., M. Trabandt, and K. Walentin (2008): “Introducing Financial Frictions and Un-

employment into a Small Open Economy Model,” Discussion Paper 214, Sveriges Riksbank (Central Bank

of Sweden).

Christoffel, K., G. Coenen, and A. Warne (2008): “The new area-wide model of the euro area -

a micro-founded open-economy model for forecasting and policy analysis,” Working Paper Series 944,

European Central Bank.

Coenen, G., G. Lombardo, F. Smets, and R. Straub (2008): “International transmission and monetary

policy cooperation,” Working Paper Series 858, European Central Bank.

Curdia, V., and M. Woodford (2008): “Credit Frictions and Optimal Monetary Policy,” Discussion

Papers 0809-02, Columbia University, Department of Economics.

20

Dedola, L., and G. Lombardo (2009): “Financial frictions, financial integration and the international

propagation of shocks,” mimeo, European Central Bank.

Demirel, U. D. (2009): “Optimal Monetary Policy in a Financially Fragile Economy,” The B.E. Journal

of Macroeconomics, 9(1).

Devereux, M. B., P. R. Lane, and J. Xu (2006): “Exchange Rates and Monetary Policy in Emerging

Market Economies,” Economic Journal, 116(511), 478–506.

**Duarte, M., and M. Obstfeld (2008): “Monetary policy in the open economy revisited: The case for
**

exchange-rate flexibility restored,” Journal of International Money and Finance, 27(6), 949–957.

Edge, R. M. (2003): “A utility-based welfare criterion in a model with endogenous capital accumulation,”

Finance and Economics Discussion Series 2003-66, Board of Governors of the Federal Reserve System

(U.S.).

Elekdag, S., and I. Tchakarov (2007): “Balance sheets, exchange rate policy, and welfare,” Journal of

Economic Dynamics and Control, 31(12), 3986–4015.

Erceg, C. J., D. W. Henderson, and A. T. Levin (2000): “Optimal monetary policy with staggered

wage and price contracts,” Journal of Monetary Economics, 46(2), 281–313.

Faia, E. (2008): “Financial Frictions and The Choice of Exchange Rate Regimes,” mimeo, Goethe University

Frankfurt.

Faia, E., and T. Monacelli (2007): “Optimal interest rate rules, asset prices, and credit frictions,” Journal

of Economic Dynamics and Control, 31(10), 3228–3254.

**Fiore, F. D., and O. Tristani (2009): “Optimal monetary policy in a model of the credit channel,”
**

Working Paper Series 1043, European Central Bank.

Gertler, M., S. Gilchrist, and F. M. Natalucci (2007): “External Constraints on Monetary Policy

and the Financial Accelerator,” Journal of Money, Credit and Banking, 39(2-3), 295–330.

**Gilchrist, S., V. Yankov, and E. Zakrajsek (2009): “Credit market shocks and economic fluctuations:
**

Evidence from corporate bond and stock markets,” Journal of Monetary Economics, 56(4), 471–493.

Kiyotaki, N., and J. Moore (1997): “Credit Cycles,” Journal of Political Economy, 105(2), 211–48.

**Levin, A. T., A. Onatski, J. C. Williams, and N. Williams (2005): “Monetary Policy Under Uncer-
**

tainty in Micro-Founded Macroeconometric Models,” NBER Working Papers 11523, National Bureau of

Economic Research, Inc.

Lombardo, G., and F. Ravenna (2009): “Trade and Optimal Monetary Policy,” mimeo.

**Ravenna, F., and C. E. Walsh (2006): “Optimal monetary policy with the cost channel,” Journal of
**

Monetary Economics, 53(2), 199–216.

**Rotemberg, J. J., and M. Woodford (1998): “An Optimization-Based Econometric Framework for the
**

Evaluation of Monetary Policy: Expanded Version,” NBER Technical Working Papers 0233, National

Bureau of Economic Research, Inc.

Schmitt-Grohe, S., and M. Uribe (2006): “Optimal Simple and Implementable Monetary and Fiscal

Rules: Expanded Version,” NBER Working Papers 12402, National Bureau of Economic Research, Inc.

Woodford, M. (2003): Interest and prices. Princeton University Press.

21

Tables and figures

Table 1. Structural parameters

**Parameter Value Description
**

Households

β 0.994 discount rate

σ 2.0 inverse of intertemporal elasticity of substitution

κ 160 weight on disutility of labour

ϕ 2.0 inverse of Frisch elasticity of labour supply

φW 4.33 elasticity of substitution between labour varieties

θW 0.75 Calvo probability for wages

γc 0.3 share of distributed tradables in consumption

α 0.6 home bias (consumption and investment goods)

Capital production and financial frictions

τ 0.025 depreciation rate

ςI 5.2 investment adjustment costs

γi 0.6 share of tradables in investment

µ 0.1 monitoring costs

ν 0.977 survival rate for entrepreneurs

σE 0.27 steady-state standard deviation of idiosyncratic productivity

Intermediate goods firms

ηN 0.38 capital share in nontradable production

ηH 0.38 capital share in tradable production

φN 3.50 elasticity of substitution between intermediate nontradable varieties

φH 5.76 elasticity of substitution between intermediate tradable varieties

θN 0.9 Calvo probability for nontradables

θH 0.75 Calvo probability for tradables

Monetary authority

ρ 0.85 interest rate smoothing

φπ 1.90 long-run response to inflation

φ∆y 0.15 response to output growth

φ∆π 0.19 response to change in inflation

22

Table 2. Stochastic processes

**Parameter Value Description
**

Autoregressive coefficients

ρt 0.85 productivity shock in tradable sector

ρn 0.85 productivity shock in nontradable sector

ρd 0.85 consumption preference shock

ρg 0.96 government spending shock

ρi 0.75 investment-specific technology shock

ρν 0.5 financial wealth shock

ρe 0.75 riskiness shock

Standard deviations

σt 0.031 productivity shock in tradable sector

σn 0.022 productivity shock in nontradable sector

σd 0.006 consumption preference shock

σg 0.0045 government spending shock

σi 0.018 investment-specific technology shock

σν 0.01 financial wealth shock

σe 0.06 riskiness shock

σm 0.001 monetary policy shock

Table 3. Steady-state ratios

Variable Value

Consumption share in GDP 58.5

Government expenditures share in GDP 21.0

Investment share in GDP 20.5

Exports share in GDP 12.0

Net exports share in GDP 0.0

Net worth share in capital 50.0

External financing premium (RE − R, annualized) 1.64

External financing premium (RB − R, annualized) 0.50

Bankruptcy rate (per quarter) 0.73

Bankruptcy costs share in output 0.27

Share of transfers to entrepreneurs in output 4.1

23

Table 4. Moment matching for the euro area

**Variable model data
**

Standard deviations

GDP 0.48 0.48

Consumption 0.48 0.48

Investment 1.31 1.31

Government spending 1.61 1.60

Inflation 0.29 0.36

Short-term interest rate 1.04 2.81

Entrepreneurs’ debt 1.16 1.53

External financing premium 1.37 0.43

Autocorrelations

GDP 0.28 0.24

Consumption 0.06 0.06

Investment 0.73 0.16

Government spending 0.96 0.96

Inflation 0.65 0.70

Short-term interest rate 0.94 0.98

Entrepreneurs’ debt 0.52 0.18

External financing premium 0.86 0.81

Correlations with GDP

Consumption 0.70 0.65

Investment 0.41 0.80

Government spending 0.01 -0.21

Inflation -0.34 -0.04

Short-term interest rate 0.01 -0.04

Entrepreneurs’ debt 0.12 0.26

External financing premium -0.05 -0.22

Other correlations

External premium-investment -0.19 -0.12

Notes: GDP components and entrepreneurs’ debt are de-

fined in log differences.

Table 5. Variance decomposition

**Shock GDP Cons. Invest. Inflation Interest Entrepr. Ex. fin.
**

rate debt premium

Productivity (T) 28.0 13.9 13.7 40.0 12.3 1.2 3.0

Productivity (NT) 28.6 30.1 4.0 38.0 32.4 3.0 4.8

Preference 7.1 35.5 0.0 0.6 2.5 0.0 0.0

Gov. spending 1.0 1.1 0.0 0.4 1.1 0.0 0.0

Inv. specific 8.5 0.7 37.3 1.7 16.3 3.9 2.7

Monetary 18.2 15.3 7.8 14.6 5.7 0.6 1.4

Entrepr. survival 2.0 3.3 32.4 4.5 29.0 90.9 39.7

Entrepr. riskiness 6.7 0.1 4.7 0.1 0.9 0.4 48.4

Notes: GDP components and entrepreneurs’ debt are defined in log differences.

24

Table 6. Welfare costs of alternative regimes: simple model

**PPI targ. CPI targ. Mon. union Taylor rules
**

No financial frictions

All shocks 0.000 0.076 0.077 0.197

Productivity shocks 0.000 0.076 0.077 0.197

Financial frictions

All shocks 0.045 0.093 0.063 0.172

Productivity shocks 0.040 0.088 0.062 0.166

Notes: All numbers are relative to the cooperative equilibrium. Welfare losses are

expressed in percent of steady-state consumption. The normalization factors (vari-

ance of output relative to the fully-fledged version of the model) are 6.7 (no financial

frictions) and 7.1 (financial frictions).

Table 7. Welfare costs of PPI targeting: various frictions

Welfare losses

Baseline 0.0000

Home bias 0.0000

Consumption habits 0.0005

Nontradable goods 0.0036

Government 0.0001

Financial frictions 0.0453

Notes: All numbers are relative to the cooperative equilibrium. Welfare

losses are expressed in percent of steady-state consumption. Baseline refers

to the simple New Keynesian model. Other rows show the consequences of

augmenting the baseline with various frictions (one at a time). The nor-

malization factors (variance of output relative to the fully-fledged version

of the model) are: 6.7 (baseline), 7.8 (home bias), 5.4 (consumption habits,

with persistence 0.57), 1.5 (nontradable goods), 4.0 (government spending)

and 7.1 (financial frictions).

Table 8. Welfare costs: the role of debt denomination

**PPI targ. CPI targ. Mon. union Taylor rules
**

Domestic currency debt denomination

All shocks 0.045 0.093 0.063 0.172

Productivity (H) 0.022 0.043 0.030 0.084

Productivity (F) 0.017 0.045 0.032 0.082

Foreign currency debt denomination

All shocks 0.056 0.100 0.069 0.179

Productivity (H) 0.000 0.054 0.040 0.093

Productivity (F) 0.052 0.042 0.029 0.083

Notes: All numbers are relative to the cooperative equilibrium. Welfare losses

are expressed in percent of steady-state consumption. The normalization factors

(variance of output relative to the fully-fledged version of the model) are 7.1

(domestic currency denomination) and 7.0 (foreign currency denomination).

25

Table 9. Welfare costs: the role of nontradables

**PPI CPI Mon. Taylor ntPPI
**

targ. targ. union rules targ.

No financial frictions

All shocks 0.004 0.074 0.132 0.269 0.047

Trad. productivity (H) 0.005 0.013 0.019 0.074 0.008

Nontrad. productivity (H) 0.003 0.019 0.043 0.083 0.003

Trad. productivity (F) -0.002 0.036 0.044 0.087 0.024

Nontrad. productivity (F) -0.001 0.006 0.024 0.020 0.012

Domestic currency debt denomination

All shocks 0.091 0.127 0.139 0.293 0.119

Trad. productivity (H) 0.047 0.020 0.017 0.073 0.008

Nontrad. productivity (H) 0.007 0.017 0.045 0.085 0.040

Trad. productivity (F) 0.005 0.044 0.036 0.072 0.015

Nontrad. productivity (F) 0.004 0.017 0.029 0.022 0.027

Foreign currency debt denomination

All shocks 0.111 0.126 0.129 0.279 0.145

Trad. productivity (H) 0.004 0.023 0.021 0.070 0.009

Nontrad. productivity (H) 0.005 0.020 0.048 0.091 0.002

Trad. productivity (F) 0.051 0.045 0.034 0.073 0.024

Nontrad. productivity (F) 0.033 0.021 0.023 0.019 0.091

Notes: All numbers are relative to the cooperative equilibrium. Welfare losses

are expressed in percent of steady-state consumption. The normalization factors

(variance of output relative to the fully-fledged version of the model) are: 1.5

(no financial frictions), 1.6 (domestic currency denomination) and 1.7 (foreign

currency denomination).

26

Table 10. Welfare costs: the role of sticky wages

**PPI CPI Mon. Taylor ntPPI Wage
**

targ. targ. union rules targ. targ.

No financial frictions

All shocks 1.171 0.646 0.133 0.264 1.106 0.023

Trad. productivity (H) 0.782 0.225 0.020 0.085 0.001 0.005

Nontrad. productivity (H) 0.063 0.044 0.043 0.080 0.768 0.008

Trad. productivity (F) 0.303 0.313 0.028 0.048 0.003 0.007

Nontrad. productivity (F) 0.029 0.066 0.039 0.031 0.338 0.003

Domestic currency debt denomination

All shocks 2.551 1.633 0.138 0.311 2.217 0.065

Trad. productivity (H) 1.652 0.630 0.016 0.069 0.023 0.005

Nontrad. productivity (H) 0.163 0.099 0.044 0.078 1.512 0.008

Trad. productivity (F) 0.661 0.735 0.022 0.040 0.011 0.005

Nontrad. productivity (F) 0.075 0.147 0.039 0.029 0.656 0.003

Foreign currency debt denomination

All shocks 2.699 1.560 0.114 0.279 2.409 0.091

Trad. productivity (H) 0.693 0.606 0.019 0.070 0.001 0.007

Nontrad. productivity (H) 0.055 0.081 0.041 0.081 0.675 0.013

Trad. productivity (F) 1.715 0.713 0.019 0.043 0.052 0.017

Nontrad. productivity (F) 0.260 0.153 0.030 0.025 1.689 0.027

Notes: All numbers are relative to the cooperative equilibrium. Welfare losses are

expressed in percent of steady-state consumption. The normalization factors (variance of

output relative to the fully-fledged version of the model) are: 1.0 (no financial frictions),

1.1 (domestic currency denomination) and 1.1 (foreign currency denomination).

27

Figure 1. Home productivity shock - simple model

**Output (H) Ext. financing premium (H) Real interest rate (H)
**

3 0 1

−0.2 0.5

2

−0.4 0

1

−0.6 −0.5

0 −0.8 −1

0 20 40 0 20 40 0 20 40

**Output (F) Ext. financing premium (F) Real interest rate (F)
**

0.4 0.1 1

0.2 0.05 0.5

0 0 0

−0.2 −0.05 −0.5

−0.4 −0.1 −1

0 20 40 0 20 40 0 20 40

**PPI inflation (H) CPI inflation (H) Terms of trade
**

0.4 2 4

0.2 3

1

0 2

0

−0.2 1

−0.4 −1 0

0 20 40 0 20 40 0 20 40

**PPI inflation (F) CPI inflation (F) Exchange rate depreciation
**

0.06 1 4

0.04

0 2

0.02

−1 0

0

−0.02 −2 −2

0 20 40 0 20 40 0 20 40

Optimal PPI targeting

**Note: The financing premium, inflation and the interest rate are expressed as percentage point
**

deviations from their steady-state levels. All remaining variables are reported as percentage devi-

ations.

28

Figure 2. Negative home net worth shock - simple model

**Output (H) Ext. financing premium (H) Real interest rate (H)
**

0.2 0.4 0.1

0.1 0.3 0

0 0.2 −0.1

−0.1 0.1 −0.2

−0.2 0 −0.3

0 20 40 0 20 40 0 20 40

**PPI inflation (H) CPI inflation (H) Exchange rate depreciation
**

0.15 0.2 0.4

0.1 0.1 0.2

0.05 0 0

0 −0.1 −0.2

−0.05 −0.2 −0.4

0 20 40 0 20 40 0 20 40

Optimal PPI targeting Union

**Note: The financing premium, inflation and the interest rate are expressed as percentage point
**

deviations from their steady-state levels. All remaining variables are reported as percentage devi-

ations.

Figure 3. Home productivity shock - dollarized debt

**Output (H) Ext. financing premium (H) Real interest rate (H)
**

3 0.1 1

0.05 0.5

2

0 0

1

−0.05 −0.5

0 −0.1 −1

0 20 40 0 20 40 0 20 40

**PPI inflation (H) CPI inflation (H) Exchange rate depreciation
**

0.5 2 4

0 1 2

−0.5 0 0

−1 −1 −2

0 20 40 0 20 40 0 20 40

Optimal PPI targeting Union

**Note: The financing premium, inflation and the interest rate are expressed as percentage point
**

deviations from their steady-state levels. All remaining variables are reported as percentage devi-

ations.

29

Figure 4. Foreign productivity shock - dollarized debt

**Output (H) Ext. financing premium (H) Real interest rate (H)
**

0.5 0 2

−0.2

0 1

−0.4

−0.5 0

−0.6

−1 −0.8 −1

0 20 40 0 20 40 0 20 40

**PPI inflation (H) CPI inflation (H) Exchange rate depreciation
**

0.6 1 2

0.4

0 0

0.2

−1 −2

0

−0.2 −2 −4

0 20 40 0 20 40 0 20 40

Optimal PPI targeting Union

**Note: The financing premium, inflation and the interest rate are expressed as percentage point
**

deviations from their steady-state levels. All remaining variables are reported as percentage devi-

ations.

Figure 5. Home tradable sector productivity shock

**Output (H) Ext. financing premium (H) Real interest rate (H) Real exchange rate
**

1.5 0.1 1 1.5

0 0.5 1

1

−0.1 0 0.5

0.5

−0.2 −0.5 0

0 −0.3 −1 −0.5

0 20 40 0 20 40 0 20 40 0 20 40

**Trad. PPI inflation (H) Nontrad. PPI inflation (H) CPI inflation (H) Exchange rate depreciation
**

0.5 0.15 0.6 2

0.1 0.4

0 1

0.05 0.2

−0.5 0

0 0

−1 −0.05 −0.2 −1

0 20 40 0 20 40 0 20 40 0 20 40

Optimal PPI targeting Union ntPPI targeting

Note: The financing premium, inflation and the interest rate are expressed as percentage point deviations from their

steady-state levels. All remaining variables are reported as percentage deviations.

30

Figure 6. Home tradable sector productivity shock - model with sticky wages

**Output (H) Ext. financing premium (H) Real interest rate (H) Wage inflation (H)
**

6 0.5 1 0.6

0 0 0.4

4

−0.5 −1 0.2

2

−1 −2 0

0 −1.5 −3 −0.2

0 20 40 0 20 40 0 20 40 0 20 40

**Trad. PPI inflation (H) Nontrad. PPI inflation (H) CPI inflation (H) Exchange rate depreciation
**

0.2 0.15 1 6

0 0.1 4

0.5

−0.2 0.05 2

0

−0.4 0 0

−0.6 −0.05 −0.5 −2

0 20 40 0 20 40 0 20 40 0 20 40

Optimal PPI targ. Union ntPPI targ. CPI targ. Wage targ.

Note: The financing premium, inflation and the interest rate are expressed as percentage point deviations from their

steady-state levels. All remaining variables are reported as percentage deviations.

Figure 7. Home nontradable sector productivity shock - model with sticky wages

**Output (H) Ext. financing premium (H) Real interest rate (H) Wage inflation (H)
**

6 0.5 1 0.6

0 0 0.4

4

−0.5 −1 0.2

2

−1 −2 0

0 −1.5 −3 −0.2

0 20 40 0 20 40 0 20 40 0 20 40

**Trad. PPI inflation (H) Nontrad. PPI inflation (H) CPI inflation (H) Exchange rate depreciation
**

0.6 0.05 1 6

0.4 0 4

0.5

0.2 −0.05 2

0

0 −0.1 0

−0.2 −0.15 −0.5 −2

0 20 40 0 20 40 0 20 40 0 20 40

Optimal PPI targ. Union ntPPI targ. CPI targ. Wage targ.

Note: The financing premium, inflation and the interest rate are expressed as percentage point deviations from their

steady-state levels. All remaining variables are reported as percentage deviations.

31

Figure 8. Foreign tradable sector productivity shock - model with sticky wages

**Output (H) Ext. financing premium (H) Real interest rate (H) Wage inflation (H)
**

2 0.5 1 0.3

0 0.2

1 0

−1 0.1

0 −0.5

−2 0

−1 −1 −3 −0.1

0 20 40 0 20 40 0 20 40 0 20 40

**Trad. PPI inflation (H) Nontrad. PPI inflation (H) CPI inflation (H) Exchange rate depreciation
**

0.3 0.06 0.5 2

0.2 0.04 0

0

0.1 0.02 −2

−0.5

0 0 −4

−0.1 −0.02 −1 −6

0 20 40 0 20 40 0 20 40 0 20 40

Optimal PPI targ. Union ntPPI targ. CPI targ. Wage targ.

steady-state levels. All remaining variables are reported as percentage deviations.

Figure 9. Foreign nontradable sector productivity shock - model with sticky wages

**Output (H) Ext. financing premium (H) Real interest rate (H) Wage inflation (H)
**

1 0.1 0.5 0.15

0 0 0.1

0.5

−0.1 −0.5 0.05

0

−0.2 −1 0

−0.5 −0.3 −1.5 −0.05

0 20 40 0 20 40 0 20 40 0 20 40

**Trad. PPI inflation (H) Nontrad. PPI inflation (H) CPI inflation (H) Exchange rate depreciation
**

0.15 0.03 0.5 2

0.1 0.02 0

0

0.05 0.01 −2

−0.5

0 0 −4

−0.05 −0.01 −1 −6

0 20 40 0 20 40 0 20 40 0 20 40

Optimal PPI targ. Union ntPPI targ. CPI targ. Wage targ.

steady-state levels. All remaining variables are reported as percentage deviations.

32

Figure 10. Negative home net worth shock - model with sticky wages

**Output (H) Ext. financing premium (H) Real interest rate (H) Wage inflation (H)
**

0.6 0.4 0.2 0.02

0.4 0.3 0

0.01

0.2 0.2 −0.2

0

0 0.1 −0.4

−0.2 0 −0.6 −0.01

0 20 40 0 20 40 0 20 40 0 20 40

**Trad. PPI inflation (H) Nontrad. PPI inflation (H) CPI inflation (H) Exchange rate depreciation
**

0.02 0.02 0.1 0.5

0.05

0.01 0.01

0 0

0 0

−0.05

−0.01 −0.01 −0.1 −0.5

0 20 40 0 20 40 0 20 40 0 20 40

Optimal PPI targ. Union ntPPI targ. CPI targ. Wage targ.

steady-state levels. All remaining variables are reported as percentage deviations.

33

Appendix

A.1 Foreign currency denomination of entrepreneurs’ debt

If loans taken by entrepreneurs are denominated in the foreign currency, the amount borrowed in the domestic

currency can be written as BE,t+1 ERt . The principal due, however, is equal to BE,t+1 ERt+1 , so that

entrepreneurs are exposed to exchange rate risk. The zero profit condition (39) thus becomes:

**RE,t+1 QT,t PC,t Kt+1 [ãE,t+1 (1 − F1,t+1 ) + (1 − µ) F2,t+1 ] = Rt∗ BE,t+1 ERt+1 (A.1)
**

Similarly, the first order condition defining the optimal debt contract (43) is now given by:

RE,t+1

ERt+1 [1 − ãE,t+1 (1 − F1,t+1 ) − F2,t+1 ] +

Rt∗

Et

ERt µ ¶ =0 (A.2)

+ 1−F1,t+11−F 1,t+1 RE,t+1

[ãE,t+1 (1 − F1,t+1 ) + (1 − µ) F2,t+1 ] − 1

−µãE,t+1 F 0 1,t+1 ∗ ERt+1

Rt ERt

**Finally, the law of motion for aggregate net worth (46) can be rewritten as:
**

" #

³ RE,t QT,t−1 PC,t−1 Kt − ´

Nt+1 = εn,t υ ∗ ERt µF2,t RE,t QT ,t−1 PC,t−1 Kt + TE,t (A.3)

− Rt−1 ERt−1 + BE,t ERt−1 BE,t ERt−1

A.2 Probability distributions

In this section we show the analytical formulas for functions of entrepreneurs’ idiosyncratic productivity

distribution. Detailed derivations can be found in Christiano et al. (2008).

If aE has a log normal distribution F with mean equal to 1, then log aE has a normal distribution with

σ2 2

mean equal to − 2E , where σE is the variance of log aE . This observation leads to the following formulas,

which we use in the derivations presented in section 2:

Z ãE,t µ 2 ¶

log ãE,t + 12 σE

F1,t = dF (aE ) = cdf (A.4)

0 σE

Z ãE,t µ ¶

log ãE,t + 12 σE2

F2,t = aE dF (aE ) = cdf − σE (A.5)

0 σE

µ 2 ¶

0 1 log ãE,t + 21 σE

F1,t = pdf (A.6)

ãE,t σE σE

where pdf (cdf ) is probability density function (cumulated distribution function) of a standard normal

distribution.

34

- Fiscal Outlook for Poland using Generational AccountsUploaded byobserwatorfinansowy.pl
- Policy Makers Votes and Predictability of Monetary Policy - November 28Uploaded byobserwatorfinansowy.pl
- Do MPC Voting Records Help Predicting Policy Interest RateUploaded byobserwatorfinansowy.pl
- A Fiscal Outlook for Poland Using Generational AccountsUploaded byobserwatorfinansowy.pl
- Antykryzysowe działania wybranych banków centralnych w latach 2007-2010Uploaded byobserwatorfinansowy.pl
- Payment Practices Study 2011Uploaded byobserwatorfinansowy.pl
- M. Prospects and Challenges AheadUploaded byobserwatorfinansowy.pl
- New Residential Salesmay 2010Uploaded byobserwatorfinansowy.pl
- Fiscal Crisis in Europe and Central AsiaUploaded byobserwatorfinansowy.pl
- Raport o Stabilnosci Systemu go 2010 07 PrezentacjaUploaded byobserwatorfinansowy.pl
- Determinanty Relacji płac Do Produktywno´ Ci Pracy:Uploaded byobserwatorfinansowy.pl
- 090327 Employment Public Aid RenewableUploaded byobserwatorfinansowy.pl
- Not What They Had in MiNd:Uploaded byobserwatorfinansowy.pl
- Fluktuacje Na Rynku PracyUploaded byobserwatorfinansowy.pl
- Opinia ZBP w sprawie Bazylei III przesłana do MFUploaded byobserwatorfinansowy.pl
- Polska wobec kryzysuUploaded byobserwatorfinansowy.pl
- 10fiscal Policy UhligUploaded byobserwatorfinansowy.pl
- Money Track 2010Uploaded byobserwatorfinansowy.pl
- GTA Report 3Uploaded byobserwatorfinansowy.pl