Peering Through Monetary Mist: Macroeconomic Effects of Monetary

Policy under Borderless World of Financial and Labor Market

Suchanan ChunanantathamJanuary 8, 2007

Presentation guide

Introduction: How did it all begin? What is it that I intend to study? How distinguish this thesis over the others in the same

area? Model summary

What is the building block behind the results? Results of the study

What is the answer to the questions at hand? Conclusion

What is the implication learned?

Introduction Objective 1

To study whether financial market integration strengthens or weakens the ability of policymakers to stabilize the economy using macroeconomic policy

Motivation A widespread acceleration in financial liberalization To the extent that such integration is a policy choice,

investigating its benefit and cost seem to be an obvious and promising direction for research

Among many aspects, the implication in term of macroeconomic policy is chosen.

Theoretical framework Classic workhorse model developed by Mundell(1962)

and Fleming (1963) Mixed results and drawbacks

Contribution New open economy macroeconomic model developed

by Ofstfeld and Rogoff (1995)

Introduction

Objective 2 To explore role played by labor market integration on the

effect of financial market integration on the adjustment of the economy to unanticipated changes in monetary policy

Motivation Most of works in international policy transmission assume

no migration of labor across countries. Through it alleviates the theoretical analysis, it is clearly at

variance with empirical evidences Contribution

Extending the model to include international labor flow would render the model to be more practical while allow for more detail study if financial market integration

Model

-Choose consumption, bond, and money holding to maximize utility subject to budget constraint

Producer- Price adjustment mechanism

Free entry and exit+ Inelastic labor supplyZero profit- Pricing rule

11

, , ,

1 1 1

1 1

Subject to (1 )

1 where

H H H H

s t

Hs t H H H Hs

s HC D M F s t s

H H H H H H H H H H Ht t t t

Ht

t t

H H H H H H H H H H H H Ht t t t t t t t

H Ht

MMax N C N N

P

N D i N D N M N M w N

P N C P N I P N N P N TZ

N Z

2

2

is given.H

H Ht

N

N I

( )( ) , here z=h,f

HH Htt tH

t

p zc z C w

P

H Hs sp w

11 111

0

( ) ( )n

H H H

n

P p h dh p f df

Government-Assume government spending is zero-Gov’t budget constraint

1( )t tt

t

M MT

P

-Each individual consumption of differentiated products need to be chosen so as to minimize the cost of attaining aggregate consumption

Consumer

Numerical results

In what follows, quantitative properties based on the previous chapter’s qualitative framework are explored.

Computational experiments No closed-form solution simulating a calibrated

version of the log-linear system numerically Method of undetermined coefficient

The results are interpreted by using impulse response analysis

Numerical results

Combination of experiments The plots, which represent the propagation of asymmetric

shock on various macroeconomic variables, are classified into four cases

Case 1: Prior to Labor Market Integration

1.1 Degree of Capital mobility: high

1.2 Degree of capital mobility: Low

Case 2: Subsequent to Labor Market Integration

2.1 Degree of Capital mobility: high

2.2 Degree of capital mobility: Low

Shock Follow Sutherland (1996), the shocks considered in this

thesis are permanent and asymmetric.

X

X

Case 1: Prior to international labor migration

First objective:

“how the degree of international financial market integration matters for the dynamics of the model in the aftermath of monetary shock with the labor market separated between nations.”

Numerical results

Numerical results

Nominal interest rate

Low barrier in making international flows of funds only one interest rate

An asymmetric shock

the interest rates are leaved unaffected by monetary shock from each country

-1 0 1 2 3 4 5 6 7 8-0.5

-0.4

-0.3

-0.2

-0.1

0

0.1

0.2

Years after shock

Per

cent

dev

iatio

n fr

om s

tead

y st

ate

-1 0 1 2 3 4 5 6 7 80

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

0.45

0.5

Years after shock

Per

cent

dev

iatio

n fr

om s

tead

y st

ate

Home Foreign

1.1 High degree of capital mobility with incomplete labor market integration: The benchmark case

General price index

Flexible-price model home price index increases by somewhat the same amount as a change in money supply.

-1 0 1 2 3 4 5 6 7 80

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

Years after shock

Per

cent

dev

iatio

n fr

om s

tead

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ate

-1 0 1 2 3 4 5 6 7 8-1

-0.9

-0.8

-0.7

-0.6

-0.5

-0.4

-0.3

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-0.1

0

Years after shock

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cent

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iatio

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ate

Numerical results

Numerical results Wage (or price of individual differentiated products)

The symmetry of both countries individual prices of goods in each country (either own-produced or imported) behave like its general price index.

So, apparently individual prices in home, which is equal to wage in the model where flexible prices guarantee zero profit, rise by one percent as well.

-1 0 1 2 3 4 5 6 7 80

0.1

0.2

0.3

0.4

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0.6

0.7

0.8

0.9

1

Years after shock

Perc

ent

devia

tion f

rom

ste

ady s

tate

-1 0 1 2 3 4 5 6 7 8-1

-0.9

-0.8

-0.7

-0.6

-0.5

-0.4

-0.3

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-0.1

0

Years after shock

Perc

ent

devia

tion f

rom

ste

ady s

tate

ˆ ˆˆˆ 0H H F F

H H H Ft t t t

N C N Cp P C C

Q Q

Numerical results Implication:

Real wage remains unchanged at the level that generates steady state full employment,

i.e., we have zero deviation of outputs from steady state

Obviously, where full employment is assured by wage

and price flexibility, monetary policy has impact that would be predicted from the basic quantity theory of money.

That is, it is only price level in an economy, not real economic variables, such as output and employment, that is affected by quantity of money.

Contradict to Sutherland (1996) where there is price-rigidity, the general level of price will change in proportion to the change in money stock, leaving the real side of economy unchanged

ˆˆ 0or 0H Ht ty Y

Consumption index (and consumption of individual goods)

Once-and-for-all step change from its initial value to a new long-run steady state level.

-1 0 1 2 3 4 5 6 7 8-0.01

0

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

Years after shock

Per

cent

dev

iatio

n fr

om s

tead

y st

ate

-1 0 1 2 3 4 5 6 7 8-0.08

-0.07

-0.06

-0.05

-0.04

-0.03

-0.02

-0.01

0

0.01

Years after shock

Per

cent

dev

iatio

n fr

om s

tead

y st

ate

Numerical results

Numerical results The main reason for flat consumption:

Unchanged real interest no incentive to reallocate consumption overtime

In other words, a country will wish to smooth consumption in the situation where a subjective discount factor is equal to the market discount factor

Not surprisingly, in presence of an efficient ways of accumulating financial wealth, countries can gain more opportunity for consumption-smoothing, as confirmed in the above two graphs.

1 1ˆ ˆ ˆ ˆˆ1H H H H Ht t t t t tC C i E P P

1 (1 )H H Ht t tC C r

Exchange rate

Exchange rate dynamic

Indeed, home currency depreciates (foreign currency appreciates) to about 2 percent.

-1 0 1 2 3 4 5 6 7 80

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

2

Years after shock

Per

cent

dev

iatio

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tead

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ate

1 ˆ ˆˆ ˆ ˆ ˆ ˆH F H F H Ft t t t t t tE M M C C i i

no change in nominal interest rate

exchange rate must also jumps immediately to its long-run level.

The relative money supply andchange in relative consumption level

once-and-for-all step change

Numerical results

No-exchange-rate-overshooting property of the model Exchange rate dynamic is virtually identical to the central

equation of the flexible-price monetary model of exchange rates

According to above equation, once domestic currency is expected to depreciate over the coming period, the today demand for domestic currency will fall, causing an increase in exchange rate immediately.

Consequently, Dornbusch-type exchange rate overshooting does not essentially occur in this model.

s m m y y i i eti i s

ets m m y y s

Numerical results

Quantity of funds transferred

Domestic agents are accumulating foreign bonds (increase in net claim on the rest of the world) as the depreciation in domestic currency gives rise to national current account surplus

-1 0 1 2 3 4 5 6 7 8-0.02

0

0.02

0.04

0.06

0.08

0.1

Years after shock

Per

cent

dev

iatio

n fr

om s

tead

y st

ate

cons

umpt

ion

valu

e

-1 0 1 2 3 4 5 6 7 8-0.1

-0.08

-0.06

-0.04

-0.02

0

0.02

Years after shock

Per

cent

dev

iatio

n fr

om s

tead

y st

ate

cons

umpt

ion

leve

l

Numerical results

Numerical results

How does presence of imperfect financial market integration affect the dynamics of the model?

Equation (1) states that the yield differential between domestic and foreign bond( i.e., the nominal interest differential less the expected depreciation of the nominal exchange rate) is proportional to expected rate of change of the cross-border flow of funds.

1 1ˆ ˆ ˆ ˆˆ ˆ1 1H F H H H H

t t t t t t t ti i E E E N C E I I (1)

1.2 Low degree of capital mobility with incomplete labor market integration

Numerical results

Algebraically, with higher value of ,

A higher negative in international nominal interest rate differential

A bigger expected rate of change in value of home currency

the initial impact on exchange rate of monetary expansion when international financial market are segmented

would be smaller

A negative expected rate of change in cross-border flow of funds

-1 0 1 2 3 4 5 6 7 8-0.5

-0.4

-0.3

-0.2

-0.1

0

0.1

0.2

Years after shock

Per

cent

dev

iatio

n fr

om s

tead

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ate

-1 0 1 2 3 4 5 6 7 80

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

0.45

0.5

Years after shock

Per

cent

dev

iatio

n fr

om s

tead

y st

ate

-1 0 1 2 3 4 5 6 7 80

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

2

Years after shock

Per

cent

dev

iatio

n fr

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tead

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ate

1 1ˆ ˆ ˆ ˆˆ ˆ1 1H F H H H H

t t t t t t t ti i E E E N C E I I

Intuitively, the central implication of imperfect capital mobility is that domestic and foreign bonds become differentiated and can, therefore, pay different rate of return.

With low capital mobility,

relatively higher downward pressure on relative yield of domestic asset

The tendency for money supply to induce higher asset accumulation in domestic economy

First, nominal interest rate of each country becomes more diverge,i.e., nominal interest rate rises in home while falls in foreign.

Second, since one component of domestic yield is capital gain arisenfrom change in exchange rate, the higher domestic yield fall implies that

expected depreciation is relatively higher.

Numerical results

Price (individual prices of home product and wage)

In keeping parity of purchasing power among the countries,

the marginally increase in E home general price index rises by less

-1 0 1 2 3 4 5 6 7 80

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

Years after shock

Per

cent

dev

iatio

n fr

om s

tead

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ate

-1 0 1 2 3 4 5 6 7 8-1

-0.9

-0.8

-0.7

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

0

Years after shockP

erce

nt d

evia

tion

from

ste

ady

stat

e

Numerical results

Numerical results Consumption (and consumption of individual goods)

Home consumption index rises sharply and then declines afterward.

Fall in real interest rate in home incentive for domestic consumers to bring consumption forward in time

When market interest rate differs from time-preference rate, the motivation to smooth consumption is modified by an incentive to tilt the consumption path.

Another reason: lower increase in price level

-1 0 1 2 3 4 5 6 7 8-0.01

0

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

Years after shock

Per

cent

dev

iatio

n fr

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ate

-1 0 1 2 3 4 5 6 7 8-0.08

-0.07

-0.06

-0.05

-0.04

-0.03

-0.02

-0.01

0

0.01

Years after shock

Per

cent

dev

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ate

First InvestigationMoney shock under different degrees of financial market

integration: Before international labors migration

Once-and-for-all in C

Once-and-for-all in E

Perfectly integrated

Price more

Output: unchange

Unchanged interest rate

Imperfectly integrated

sharply and afterward

E by less

Price less

Output: unchange

Interest rate-

+

+

--1 0 1 2 3 4 5 6 7 8

-0.5

-0.4

-0.3

-0.2

-0.1

0

0.1

0.2

Years after shock

Per

cent

dev

iatio

n fro

m s

tead

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ate

-1 0 1 2 3 4 5 6 7 8-0.01

0

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

Years after shock

Per

cent

dev

iatio

n fr

om s

tead

y st

ate

-1 0 1 2 3 4 5 6 7 80

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

2

Years after shock

Per

cent

dev

iatio

n fr

om s

tead

y st

ate

-1 0 1 2 3 4 5 6 7 80

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

Years after shock

Per

cent

dev

iatio

n fr

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tead

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ate

Numerical results

ˆˆ 0or 0H Ht ty Y

Numerical results

In other words, at any degree of labor market integration, it would be sufficient to establish the financial market integration as the factor that reduces volatility of interest rates and increases in volatility of prices and exchange rate.

Hence, along the lines of Mundell-Fleming model and Sutherland (1996), the monetary policy effect toward exchange rate tends to be stronger, the higher is the degree of international capital mobility.

On the other hand, while it enhances the effect on exchange rate, its effect on output deteriorates as perfectly flexible prices and wages bring about the classic neutrality property of monetary policy.

Case 2: Subsequent to international labor migration

Second objective

“ Whether implications of international capital mobility for the macroeconomic effects of monetary policy are sensitive to the extent of integration in international labor market.”

Numerical results

Comparing between incomplete and complete labor market integration, it go without saying that

As before, the implications of lowering in trading friction in international financial transaction on monetary policy effects work through

the presence of international labors resettlement

the way any of macro variables response to shock from what is analyzed in the last section.

does not significantly alter

the interaction of relative asset return and exchange rate

Numerical results

Numerical results

After the lower impediments to cross-country capital flows are introduced, the fall in relative yield from holding assets in different countries is smaller.

This, simultaneously, means two things. The deviation of interest differential between domestic and foreign

bond becomes narrower

1 1ˆ ˆ1 ˆ ˆ ˆ1 ˆ H H H H

t t t ttH

t tF

t E E E N C E Ii i I

-1 0 1 2 3 4 5 6 7 8-1.2

-1

-0.8

-0.6

-0.4

-0.2

0

0.2

0.4

Years after shock

Pe

rcent devi

atio

n fro

m s

tea

dy

state

-1 0 1 2 3 4 5 6 7 8-0.1

-0.05

0

0.05

0.1

0.15

0.2

0.25

Years after shock

Pe

rce

nt

de

via

tion

fro

m s

tea

dy

sta

te

Home

Foreign

Because of the higher expected inflation in domestic economy as a result of greater monetary-induce exchange rate depreciation in the case where home agents can easily switch places to invest their assets the borrowers and lenders add inflation premium to interest rate. Ultimately, an expansion in money supply in home will raise interest rate when financial market integration is highly complete. “expected inflation effect”

Numerical results

The magnitude of an increase in depreciation expectation is getting smaller.

In contrast to the case where a nation’s capital market is less loosen up, lower expected depreciation generates dramatically higher monetary-induced increase in exchange rate, as confirmed by the following diagram.

-1 0 1 2 3 4 5 6 7 80

0.5

1

1.5

2

2.5

3

3.5

4

4.5

Years after shock

Per

cent

dev

iatio

n fr

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tead

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ate

1 1ˆ ˆˆ ˆˆ1 1 ˆH F H H H H

t t t tt tt tE Ei i N C I IE E

The nominal exchange rate increases by more from an symmetric shock in a relative money supply, as compared to the case previous to migration.

It appears from the equation that the relative difference between returns from holding assets of home and foreign country becomes smaller after labors relocate from home to foreign.

The smaller yield differential, then, implies that the expected domestic currency depreciation happens to be less significant in the world of high worldwide labor mobility.

So, with lower depreciation expected, it is necessary for the impact effect of monetary change on exchange rate to be larger

, i.e., higher depreciation (in either low or high degree of financial market integration) if labors are allowed to migrate.

1 1ˆ ˆ ˆ ˆˆ ˆ1 1H F H H

t t t t t ttH H

tN Ci i E E E E I I

Numerical results

How are things different in the presence of global linkages in labor market?

Armed with the dynamics of exchange rate, we can determine

If we compare to the world where difficulties in undertaking position in oversea financial market is more important, asymmetric shock in money supply causes home general price index and wage (or price of individual goods) to rise by more as it produces a bigger rate of home currency depreciation.

-1 0 1 2 3 4 5 6 7 80

0.5

1

1.5

2

2.5

3

3.5

Years after shock

Pe

rce

nt

de

via

tion

fro

m s

tea

dy

sta

te

-1 0 1 2 3 4 5 6 7 80

0.5

1

1.5

2

2.5

3

Years after shock

Pe

rce

nt

de

via

tion

fro

m s

tea

dy

sta

te

Price Wage

the effect of monetary policy change on other macro variables.

Numerical results

The direct effect of a change in the location of production on price index of that country:

After a given amount of home labors move to foreign country, steady state value of home total outputs, as well as the

number of varieties home produces, decline. This raises positive effect of expansionary monetary policy

on home price.

Accordingly, we can notice a larger rise in home price index, as compared to the circumstances before labor market integration.

Numerical results

“Price index effect”:Price index in a particular region would tend to be higher,the lower is the share of production sector in that region.

How are things different in the presence of global linkages in labor market?

Wage: Because a substantial depreciation in home currency creates

a higher demand for home products at the expense of foreign products,

moving of home labors to foreign country would appear to raise home wages up higher after the disturbance hits the economy.

Therefore, an asymmetric change in monetary policy would

cause a higher rise in home wage rate if labor is mobile across regions.

“Home market effect”With the vertical labor supply curve,

the producers in location with larger demand for its product would have to pay a higher nominal wage.

Numerical results

Dynamics of consumption and current account

In fact, home consumption climbs down by more, thus leading to greater current account surplus when the two financial markets are highly integrated.

• Of course, this is attributed to the higher increases in domestic price + smaller fall in domestic interest falls when countries become less isolated to the global financial market -1 0 1 2 3 4 5 6 7 8

-14

-12

-10

-8

-6

-4

-2

0

Years after shock

Per

cent

dev

iatio

n fro

m s

tead

y st

ate

Expansionary monetary policy in home gives rise toa fall in consumption, instead of raising it as it does in the caseahead of home emigration.

•This is so because it generates a much higher rise in price level,which implies a lower purchasing power and thus the incentive to spending.

•Plus, the fact the home interest rate fall by less as a result of money supply increase means that agents will wish to consume relatively more in the future, rather than now. Consequently, in the below panel, as the disturbance strikes,home consumption declines once labor is highly mobile across countries.

Numerical results

Second Investigation: Implications of international capital mobility for the effects of monetary policy: After

international labors migration

E more

Price more

Perfectly integrated

C more

Output: unchange

interest rate

Imperfectly integrated

E less

Price less

C less

Output: unchange

Interest rate

+

+

-+

Numerical results

ˆˆ 0or 0H Ht ty Y

-1 0 1 2 3 4 5 6 7 8-1.2

-1

-0.8

-0.6

-0.4

-0.2

0

0.2

0.4

Years after shock

Perc

ent devi

atio

n fro

m s

teady

state

-1 0 1 2 3 4 5 6 7 8-14

-12

-10

-8

-6

-4

-2

0

Years after shock

Per

cent

dev

iatio

n fro

m s

tead

y st

ate

-1 0 1 2 3 4 5 6 7 80

0.5

1

1.5

2

2.5

3

3.5

4

4.5

Years after shock

Per

cent

dev

iatio

n fr

om s

tead

y st

ate

-1 0 1 2 3 4 5 6 7 80

0.5

1

1.5

2

2.5

3

3.5

Years after shock

Per

cent

dev

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ate

Summary of simulation results

In the nutshell, the simulated results carried out at different degrees of financial and labor market integration ultimately indicate that

1) The way macroeconomic variables response after money shock hit economy obviously differs between economy with low and high capital mobility

Cases

Financial market integration

(i) Imperfect integrated labor market - - + + 0

(ii) Perfectly integrated labor market -* + + + 0

, ( )P p zE,i r , ( )C c z ( ),y z Y

Accordingly, although the approach taken here differs radically from that of traditional Mundell-Fleming model in that it allows policy issues to be analyzed by mean of full-fledged micro-founded dynamic model, the two approach share some implications as both models appear to predict that the nominal exchange rate effect of monetary policy tend to increase in the world where capital mobility is far above the ground.

At the same time, the flexile-price NOEM model developed in this paper and the quantity theorist also are not extremely far apart in terms of output implication of monetary policy.

Eventually, money is all that matters for change in nominal, not real, income, as reflected clearly in the basic quantity theory of money.

Summary of simulation results

Summary of simulation results2) Another interesting results concern the impact of having a

particular amount of labors migrates from home to foreign country.

As a consequence, regardless of the condition in terms of linkage in labor market of each nation, the international financial market integration does show a consistent and dependable effect toward the behavior of economy in the upshot of shock in money supply.

The simulation results suggest that quite the same pattern still applies even after the possibility of shift in labor location is incorporated.

Cases

Financial market integration

(i) Imperfect integrated labor market - - + + 0

(ii) Perfectly integrated labor market -* + + + 0

, ( )P p zE,i r , ( )C c z ( ),y z Y

The end

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