Monetary Policy and Accumulation of Reserves in an Emerging Economy: A DSGE Model for the Colombian Case
Politica monetaria e acumulacao de reservas em uma economia emergente: um modelo DSGE para o caso colombiano
According to Blanchard et al (2012), "before the economic crisis began in 2008, mainstream economists and policymakers converged on a beautiful construction for monetary policy. To caricature just a bit: we had convinced ourselves that there was one target, inflation, and one instrument, the policy rate. And that was basically enough to get things done". But the crisis has shown the fallacy of this construction: it is not evident that stable inflation is enough to get a small and constant output gap. Excessive leverage of households, firms and government could produce bubbles in asset prices, and consequently could deeply destabilize the economy. On the other hand, excessive leverage by the financial sector could produce an unusual increase in risk levels (frequently originated from asymmetric information conditions, associated with the "moral hazard" concept) that can lead to a sudden stop in the economic activity. Consequently, both asset prices and leverage of economic agents became essential elements, even though we are far from knowing in detail how they influence the economy and how some warnings signals could be considered in the analysis. As a result, economist have a double requirement: first, to explicitly consider the asset prices gap in monetary policy and second, to include agents leverage in the monitoring of economic evolution.
These changes in defining monetary policy go along with the fact that, in developed countries, intervention interest rates have reached their effective lower bound. This has forced these countries to use non-conventional monetary policies implying new problems of consistency and communication, and thus making the monetary policy more complex, as it is pointed out by some authors such as English et al. (2015).
Thus, not only decisions on short-term interest rates can have an influence on asset prices (1) and agents leverage. There are also other monetary policy instruments that have an influence on them: decisions on liquidity provisions, monetary aggregate management, other forms of credit expansion, formation of expectation on future interest rate through forward guidance and macroprudential policies. Additionally, for emerging economies, it is necessary to incorporate foreign exchange interventions in the monetary policy management. Those interventions could affect the use of conventional instruments, or constitute an alternative goal of the monetary policy, as shown by Ostry (2012). Many central banks only recognize the marginal presence of the exchange rate in their monetary management through its inflation impact. But the exchange rate has an essential role, not only for its impact on economy's competitiveness, but also for its predominant role in foreign exchange holdings in the balance sheet of central banks.
In this context, Vargas et al. (2013) analyze how the Colombian central bank has been intervening in the foreign exchange market and the immediate aims of this intervention. The final objectives of intervention in Colombia have been restricted to three elements, namely: maintenance of a proper level of international reserves, correction of the exchange rate misalignment from its long-term equilibrium level, and, sometimes, the control of its volatility through option auctions where it is possible to buy and sell foreign currency according to its representative market rate in relation with its moving average value during the last twenty days. The bank's policy has been focused on sterilized exchange interventions in order to maintain the short-term interest rate in the direction of the policy interest rate.
In conclusion, the link between inflation stability and product is not clear, and new objectives must be considered: asset prices, agents leverage, financial stability and exchange rate. According to this, new instruments are also needed: massive interventions in credit markets, macro-prudential policies to mitigate systemic risks, forward guidance to influence the future interest rate, interventions in the foreign exchange market and control over capital flows. Extending the scheme proposed by Blanchard et al. (2012), it could be affirmed that if the simple scheme in Figure 1 could be enough to represent the monetary policy before the great recession, now a more complete scheme, such as the one shown in Figure 2, would be necessary.
This complex scheme has a mixed set of macro-prudential policies and balance sheet measures directly affecting financial stability, but also affecting inflation and product. The interest rate conventional policy now completed with forward guidance affects the traditional prices and the output gap, and similarly impacts the financial stability and the exchange rate. The foreign exchange insterventions influence the exchange rate, prices and product. In this scheme, not only the central bank's balance sheet recovers its main role in implementing the monetary policy, but also the monetary authority has a complete tool box at its disposition to influence gaps in inflation, output and the system risk that affect the economic activity.
The economic world crisis between 2008 and 2013 has had and will continue to have colossal consequences over economic thinking, the beliefs in free markets and the role of monetary policy. (2) There has been (and there will continue to be) a rich discussion about these topics, but only time will give us the right perception about what happened (Blinder, 2013). However, some conclusions seem to be obvious, at least for those who work in modeling related topics. First, the microeconomic attention given to the financial sector has been deficient and inadequate; second, although some important advances have been made in financial frictions analysis, their role remain marginal in economic modeling; and third, attention provided to asset price bubbles in modeling has been insufficient.
In the same way, there are also some immediate lessons related to monetary policy: (3) the consensus reached about "inflation targeting" scheme, despite the fact that it achieved a fundamental role in the first decade of 21st century, is inadequate today. Excessive emphasis on the short-term interest rate as a monetary policy essential instrument has been seriously questioned after continuous events of "quantitative easing". The exclusive attention given to inflation and the output gap seems having forgotten essential topics, which have been decisive during the last years: the relation between financial instability and price bubbles, and the role of "macro-prudential" policies in the economic system stabilization. (4)
Given all those considerations, our model aims at advancing towards two aspects: incorporating the financial sector into modeling as an optimizer agent with enormous relevance in economy and making the "balance sheet" of the central bank explicit. We pretend to allow a broader monetary policy vision and to clarify the link between this policy and the foreign exchange policy, which in an emergent and small economy such as Colombia depends essentially on the central bank.
To precisely describe the role of the financial sector in the economy, it is crucial to explain the role of different agents in the financial system such as borrowers or lenders. Specifically, this model supposes that "households" (main private agents in the economic system) play as resource suppliers in the financial system and a new type of agents ("investment companies") play as demander of these resources. Investment companies are neutral risk agents, who are looking for new investment opportunities in productive fixed assets and maximizing their expected benefits. These benefits are defined as the difference between investment revenues (obtained by leasing assets for firms that use them for productive processes), and the investment cost, which includes not only the asset value, but also the convex adjust costs that reflect the growing difficulty to adjust productive asset levels to their optimum point. (5)
For the central bank, the model makes its balance sheet clear, including money supply, credit operations with the financial sector and a fundamental asset for emerging countries such as Colombia: international reserves.
The reference to the balance sheet of the central bank, and the consideration of the optimum decision of financial intermediaries (and their budget constraints), allow us to analyze in detail the traditional monetary aggregates, M1 and M3, which are included in the system, allowing the analysis of expansive policies implemented through the variation of money supply. This is important, firstly, because the prevalence of nominal interest rates close to zero in almost all developed countries during 2009-2015 limits the use of conventional monetary policies. Secondly, because the foreign exchange policy used in emerging countries, mainly through the balance sheet of the central bank, due to the great participation of reserves in their total asset levels.
We identified three different research strands in the monetary policy recent development: the first one introduces financial frictions related to credit constraints faced by non-financial agents in the DSGE standard model; the second one analyzes these frictions in financial intermediaries, particularly the banks; and, the third one, analyzes the relation between monetary and macroprudential policies.
Concerning the first research strand mentioned above, it is essential to introduce the "financial accelerator" concept. The main studies regarding this subject are Bernanke et al. (1999), Smets and Wouters (2003, 2007), Christensen and Dib (2005), and Christiano et al. (2010). They found that the existence of agency problems in financial...