BIS Working Papers. Globalisation, passthrough. policy response to exchange rates. No 450. Monetary and Economic Department

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1 BIS Working Papers No 450 Globalisaion, passhrough and he opimal policy response o exchange raes by Michael B Devereux and James Yeman Moneary and Economic Deparmen June 014 JEL classificaion: E58, F6 Keywords: globalisaion; foreign exchange inervenion; exchange rae pass-hrough

2 BIS Working Papers are wrien by members of he Moneary and Economic Deparmen of he Bank for Inernaional Selemens, and from ime o ime by oher economiss, and are published by he Bank. The papers are on subjecs of opical ineres and are echnical in characer. The views expressed in hem are hose of heir auhors and no necessarily he views of he BIS. This publicaion is available on he BIS websie (www.bis.org). Bank for Inernaional Selemens 014. All righs reserved. Brief excerps may be reproduced or ranslaed provided he source is saed. ISSN (prin) ISSN (online) ISBN (prin) ISBN (online)

3 Globalisaion, pass-hrough and he opimal policy response o exchange raes Michael B Devereux and James Yeman 1 Absrac In his paper we examine how moneary policy should respond o nominal exchange raes in a New Keynesian open economy model ha allows for a non-rivial role for serilised inervenion. The paper develops he argumen agains he backdrop of he evolving policy-making environmen of Asian economies. Serilised inervenion can be a poen ool ha offers policymakers an addiional degree of freedom in maximising global welfare. We show ha he gains o serilised inervenion are greaer when goods marke inegraion is low and exchange rae pass-hrough is high. However, increased financial inernaionalisaion reduces he effeciveness of serilised inervenion, as he inernaional policy rilemma becomes more relevan. Unserilised inervenion may also have a role o play, alhough he poenial welfare gains from his are generally smaller. Mos cenral banks in Asia have acively used serilised foreign exchange inervenion as a policy ool o smooh exchange raes. Bu, over ime, declining exchange rae pass-hrough and he increasing inernaional inegraion of financial and goods markes will end o reduce he efficacy of serilised inervenion. Given he limied effeciveness of unserilised inervenion, our model implies ha he role of exchange rae movemens in he opimal seing of moneary policy in Asia is decreasing. Keywords: globalisaion; foreign exchange inervenion; exchange rae pass-hrough JEL classificaions: E58, F6 1. Inroducion How should cenral banks respond o exchange rae changes? Hisorically, economies in Asia have placed a high weigh on nominal exchange rae sabiliy. Moreover, sabilising he exernal value of he currency appears o have served as an effecive nominal anchor for he economies in he region. Bu, Asian economies have been changing rapidly in erms of heir indusrial and financial marke srucure, and he choice of opimal nominal anchor is likely o evolve along wih hese changes. In his paper, we assess he naure of srucural changes in Asian economies, and discuss heir implicaions for he role of he nominal exchange rae in moneary policy. In he pas, goods marke inegraion was relaively low in Asia. Domesic consumpion was heavily weighed owards domesically produced goods, and rade was concenraed in raw maerial impors and finished good expors inended for he so-called advanced economies. The degree of exchange rae pass-hrough o domesic prices also ended o be high. Any change in he exchange rae was likely o quickly show up as a corresponding change in domesic price levels. Under such condiions, here is a high degree of complemenariy beween exchange rae sabiliy and inflaion sabiliy, and exchange rae changes can play a powerful real role by generaing expendiure swiching. 1 Universiy of Briish Columbia, Vancouver, BC V6T 1Z1, Canada and Bank for Inernaional Selemens, 78h Floor, Two IFC, 8 Finance Sree, Cenral, Hong Kong. The opinions in his paper are hose of he auhors are no necessarily shared by he Bank for Inernaional Selemens. We hank Lillie Lam, Pablo Garcia-Luna, Giovanni Sgro and Ba-el Berger for excellen research assisance and Aaron Mehrora, Ippei Fujiwara and paricipans of seminars a he Reserve Bank of Ausralia and Universiy of Canerbury and conferences hosed by he People s Bank of China-BIS, Reserve Bank of New Zealand and Ciy Universiy of Hong Kong-JIMF for helpful commens. Any remaining errors are solely our responsibiliy. 1

4 Anoher key characerisic of previous decades was relaively low levels of financial inernaionalisaion. Domesic financial markes were relaively underdeveloped. Exernal invesors had lile choice of domesic asses ha hey could purchase, and effecive capial conrols furher limied he scope for inernaional risk sharing. In such an environmen, official holdings of foreign exchange reserves may be an effecive subsiue for privae holdings in increasing inernaional risk sharing and improving global welfare. Bu, as we documen below, hese hree characerisics have changed. Goods markes have become more inegraed in Asia as consumer preferences across differen economies have moved closer ogeher. By mos merics, he degree of exchange rae pass-hrough has fallen. As average inflaion raes have come down, prices have ended o become sickier, slowing he rae a which exchange rae shocks are passed on o domesic price levels. Also, regional financial markes are now more inegraed wih global markes. Clearly here are sill large deviaions from complee inernaional risk sharing bu he combinaion of developing domesic financial markes in he region, and declining barriers o inernaional capial flows, have seen increased financial globalisaion. We capure hese characerisics in a New Keynesian model in he following ways. Increases in he degree of goods marke inegraion are represened by a reducion in he degree of home bias in he consumer s uiliy funcion. To allow for variaion in he degree of underlying exchange rae passhough, our model assumes ha some porion of impors is priced in local currency, wih he remainder priced in he producers currency. In addiion, we have varying degrees of financial inegraion, from financial auarky o full inernaional risk-sharing. This paper argues ha hese rends in exchange rae pass-hrough and financial marke and goods marke inegraion have imporan implicaions for he conduc of moneary policy. In paricular, he effec of hese developmens is o reduce he gains o using serilised inervenion o influence exchange raes. In he limi, as financial inernaionalisaion increases, serilised inervenion becomes incapable of influencing exchange raes a all. And if goods marke inegraion were o become complee, we find ha here would be no gains in welfare erms from influencing exchange raes using eiher serilised or unserilised inervenion. Alhough increasing financial inegraion reduces he usefulness of serilised inervenion, his does no leave policymakers compleely wihou effecive ools for influencing exchange raes. In response o boh produciviy and cos-push shocks, here generally remains a small role for unserilised inervenion o improve global welfare. While our model is highly sylised along a number of dimensions (for example, we do no include a role for invesmen, or a mercanilis moive for foreign exchange inervenion), we view our model as capuring some of he mos salien feaures of some of he middle- and higher-income economies in Asia, such as Korea, Malaysia and Thailand, who follow an inflaion arge in addiion o subsaniallyserilised inervenions in foreign exchange markes. The connecion beween hese economies and he experimens underaken wih he model is developed more fully below. Our paper adds o he exising lieraure on he desirabiliy of sabilising exchange raes. For example, Taylor (001) reviews he lieraure on including he exchange rae in moneary policy reacion funcions and finds ha his can resul in only modes improvemens (or even a deerioraion) in erms of oupu and inflaion oucomes in sandard small open economy macro models. Garcia e al (011) argue ha a cenral bank response o exchange raes may be desirable, especially in financially vulnerable economies (defined as hose where agens have limied access o saving and borrowing faciliies, limiing ineremporal opimisaion). 3 Suherland (005) shows ha he opimal variance of exchange raes depends 3 See Mussa e al (000) for a summary of he various facors ha may influence he opimal choice of exchange rae regime. See also Cespedes e al (004) and Moron and Winkelried (005).

5 on a variey of facors, including he degree of pass-hrough, he size and openness of he economy, he elasiciy of labour supply and he volailiy of foreign producer prices. Engel (011) argues ha moneary policy should respond o currency misalignmens, which cause inefficien oucomes because home and foreign households pay differen prices for he same goods. Corsei and Peseni (005) demonsrae ha using moneary policy o reduce exchange rae volailiy may be welfare enhancing, even if i leads o increased oupu gap volailiy, because risk-averse foreign exporers are likely o reduce average mark-ups in response o decreased exchange rae volailiy. Devereux (004) shows ha, in a world wih nominal rigidiies and incomplee inernaional financial markes, hen, even if a flexible nominal exchange rae would serve as a perfec shock absorber, fixed exchange raes may be preferable. Effecively, flexible exchange raes can lead o inefficien oupu responses o demand shocks in ha oupu may be oo sable. In his paper, we obain similar resuls o Devereux in he case of financial auarky. However, we find ha his argumen is weakened as financial markes become more inernaionalised. In he nex secion we discuss he recen evoluion of Asian economies, focusing on changes ha migh warran a reconsideraion of he role of exchange raes in moneary policy. We provide empirical suppor for he hree key elemens of our model increasing goods and financial marke inegraion and decreasing exchange rae pass-hrough based on he recen experience of nine Asian economies. Secion 3 discusses he range of possible policy responses o exchange rae developmens. In Secion 4 we ouline an open economy model ha we use o analyse he effec of on-going changes in Asian economies, and heir implicaions for he use of boh serilised and unserilised inervenion. We discuss he resuls from our model in Secion 5. Finally, Secion 6 concludes.. The evoluion of emerging Asian economies Recen decades have winessed many changes in he srucure of Asian economies. Three facors are of paricular relevance o he radiional desire by cenral banks in he region o sabilise nominal exchange raes. Firs, exchange rae pass-hrough o inflaion appears o now be low. To show his, we esimae a simple vecor auoregression, economy-by-economy, on quarerly daa for real GDP growh, inflaion, he change in he policy rae and he change in he nominal effecive change rae, in ha order. 4 We also include four seasonal dummies and hree lags. The model is idenified by orhogonalising he reducedform errors by means of a Choleski decomposiion of he variance-covariance marix. We hen compue he impulse response of inflaion, in per cen, o a 10% depreciaion shock o he nominal effecive exchange rae. We use Mone Carlo mehods and plo he median projecion along wih he 10 h and 90 h perceniles (as confidence bands) in Graph 1. 5 Our resuls sugges ha exchange rae pass-hrough for many economies in Asia has been low for some ime. The poin-esimae of he peak increase in inflaion following a 10% depreciaion in he nominal effecive exchange rae is 0.7% or lower for mos economies, wih he excepions of Hong Kong (1.1%), China (1.3%) and Indonesia (.6%). However, he relaively high rae of pass-hrough in Indonesia is driven enirely by observaions around he ime of he Asian Financial Crisis: if we insead sar he daa sample in 001, for example, he peak increase in inflaion drops o 1.0%. 4 5 Our variables are defined as he quarer-on-quarer change in he log of he level for real GDP, he CPI and he nominal effecive exchange rae, and he change in he level for he policy rae. Sample periods depend on daa availabiliy and vary beween 1994Q1-01Q4 (China, Hong Kong, Korea, Malaysia, Philippines, Thailand), 1994Q1-01Q3 (Singapore), 1996Q1-01Q4 (Indonesia) and 1996Q-01Q3 (India). 3

6 We are no he firs o quesion he received wisdom ha exchange rae pass-hrough remains high in emerging marke economies. Brun-Aguerre e al (01) find ha shor-run pass-hrough in emerging marke economies is low and close o ha for advanced economies. 6 Impulse response of CPI inflaion o NEER shock 10% depreciaion Graph 1 China Hong Kong SAR India Indonesia Korea Malaysia Philippines Singapore Thailand Verical axis in per cen. Dashed lines display 80 per cen confidence bands The lieraure offers a number of possible explanaions for declining exchange rae pass-hrough ha are likely o apply in he Asian conex. For example, improved inflaion conrol, leading o declines in boh he level and volailiy of inflaion, is associaed empirically wih lower levels of exchange rae passhrough, as prices become more sicky (Devereux and Yeman, 010; Choudry and Hakura, 006; Gagnon and Ihrig, 004). 7 For Asian economies wih a hisory of high inflaion, he improvemen in inflaion 6 7 See, also, Ca Zorzi e al (007) and Mihaljek and Klau (008). Care should be aken in giving a decline in pass-hrough a srucural inerpreaion, however. Improved inflaion oucomes are likely o presen as evidence of declining pass-hrough regardless of any underlying srucural changes. This is because, he 4

7 ouurns has been subsanial. Average inflaion in China and Indonesia declined by almos one half from o Mos oher regional economies have seen subsanial, alhough smaller, declines in inflaion beween hese same wo periods. Oher explanaions include changes in he composiion of impor bundles, from high pass-hrough commodiies o lower pass-hrough manufacured goods and food producs (Campa and Goldberg, 005) and increased rade in final goods (Choi and Cook, 013). The up-sho of declining pass-hrough is ha he effeciveness of exchange rae conrol as a policy lever may be declining, for wo reasons. Firs, declining pass-hrough implies a weakening link beween exchange rae sabiliy and inflaion sabiliy. To he exen ha exchange rae movemens are a source of macroeconomic volailiy, less exchange rae pass-hrough decreases he domesic macroeconomic benefis from sabilising he exchange rae. And second, where exchange raes are acively used as a ool for domesic business cycle managemen o offse oher shocks, if domesic prices fail o adjus, here will be lile expendiure-swiching in response o exchange rae changes. Adjusing he exchange rae in response o shocks in a low pass-hrough environmen will have smaller effecs on he demand for domesically produced goods han in a high pass-hrough environmen. 8 A second changing dynamic ha may influence he role of he exchange rae is he ongoing inegraion of goods markes. Graph illusraes he growh in rade volumes over ime. One consequence of his is ha consumpion bundles are becoming increasingly similar across economies over ime. As we will see, in our model, he mechanics of inernaional risk sharing depend in par on he degree o which consumpion bundles overlap beween economies. Trade inegraion Impors plus expors of goods and services as a percenage of GDP Graph Simple average across economies Aggregaed raio Asia ex-japan a All economies b 30 a China, Hong Kong SAR, India, Indonesia, Korea, Malaysia, Philippines, Singapore and Thailand. b 50 major economies. Source: IMF World Economic Oulook, April 013. more sable inflaion is, he less correlaed inflaion will end o be wih any poenial explanaory variables, including exchange raes, as Parsley and Popper (1998) argue. Similarly, Reyes (007) argues ha successful currency inervenion o smooh exchange rae changes may resul in he appearance of reduced pass-hrough, even if pricing behaviour is unchanged. 8 If insead of focusing on he role of he exchange rae as a policy ool ha can be used o influence he real economy we focus on is role as a price ha adjuss in response o shocks, he logic reverses. As Devereux and Engel (003) argue, he case for exchange rae flexibiliy ress in par on prices responding o exchange raes so as o simulae expendiure swiching. For a more general discussion of pass-hrough, see Bursein and Gopinah (013). 5

8 A hird characerisic ha may be imporan for he policy rade-offs ha cenral banks face is increasing financial inernaionalisaion. One simple meric of his is gross inernaional invesmen posiions, which have grown dramaically in recen years. As of end-01, gross inernaional posiions as a share of GDP were a all-ime highs for many regional economies. One consequence of financial inernaionalisaion is ha inernaional risk sharing is likely o be increasing. A sandard es for risk sharing is o esimae an equaion of he form: logc log C ( logy log Y), (1) i i i i where C i ( Y i ) is real consumpion (oupu) for economy i and C ( Y ) is world real consumpion (oupu) in period, where all variables are measured in per capia erms. 9 The esimae of is a measure of risk-sharing, wih 0 implying full risk-sharing. While he inernaional evidence of increasing risk sharing using his approach repored elsewhere ends o be limied, we find srong evidence for growing risk-sharing for economies in Asia. Graph 3 plos panel esimaes of, ogeher wih 95% confidence bands based on robus sandard errors, for he nine economies displayed in Graph 1, on 15-year rolling samples, for four differen specificaions: oneyear, five-year and en-year differences in consumpion and oupu, and in levels. Clearly here has been a noiceable decline in he esimaes over he sample in all cases, consisen wih increasing risk-sharing. Asia ex-japan risk sharing a Graph 3 1-year differences 5-year differences 10-year differences Levels Esimaed β 95% conf a China, Hong Kong SAR, India, Indonesia, Korea, Malaysia, Philippines, Singapore and Thailand. Devereux and Suherland (008) examined wheher increased inernaional asse posiions in hemselves influence opimal moneary policy. Afer all, when inernaional posiions are large, exchange rae movemens may have considerable wealh effecs. However, hey show ha when large asse posiions are he resul of efficien porfolio choices, exchange rae movemens are an imporan ingredien in ensuring he opimal sharing of risk. Thus large inernaional posiions per se do no suppor he need for exchange rae sabiliy. 9 See, for example, Bai and Zhang (01) and Kose e al (009). As is common in his lieraure, we use daa from Penn World Tables 8.0 o consruc consumpion and oupu measures per capia o esimae his equaion. In compuing global measures, we include all 107 economies ha are presen in he daase no laer han

9 More generally, our graphical evidence is suggesive ha he economies in emerging Asia are increasingly inernaionalised and inegraed ino global financial markes. One pracical implicaion of his is ha he scope for policymakers o use serilised foreign exchange inervenion o sabilise exchange rae movemens may be becoming more limied. Indeed, in he limi, if financial markes are fully inegraed and asse markes are complee, hen he implicaions of he policy rilemma are likely o become sark, as we will show. While efficien markes and full risk sharing are unlikely in realiy, he underlying principle of reduced effeciveness of foreign exchange inervenion as financial inernaionalisaion increases is likely o be a pracical consrain on policymakers acions. Effecively, cenral bankers may sill be able o influence exchange raes as financial inernaionalisaion increases, bu no wihou having o sacrifice some degree of domesic moneary conrol. In pracical erms, as we will laer model, increased financial openness reduces he possibiliy of serilised inervenion where he exchange rae can be conrolled wihou changing domesic ineres raes while leaving open he possibiliy of unserilised inervenion. 10 Taking all our argumens ogeher, here is increasing evidence ha some of he hisorical moivaions for wha have lain a he hear of he so-called fear of floaing (Calvo and Reinhar, 00) have declined. Decreased exchange rae pass-hrough and ongoing goods and financial marke inernaionalisaion may now allow for a reassessmen of he imporance of exchange rae sabiliy in achieving moneary policy goals. In Secion 4, we will develop an analyical model o address his quesion. Bu firs, we discuss curren cenral bank responses o exchange rae movemens in Asia. 3. Policy responses o exchange raes In many Asian economies, a common policy response o exchange rae flucuaions has been foreign exchange inervenion, inended o smooh he pah of exchange raes. Mohany and Klau (004) found ha some emerging marke economies respond more srongly o exchange rae movemens han o eiher inflaion or he oupu gap. Filardo e al (011) provided a summary of how emerging marke economy cenral banks respond o exchange raes and repored ha cenral banks managed he value of heir currencies more acively in he afermah of he inernaional financial crisis han before. One consequence of aemps o manage exchange raes has been he massive expansion of foreign exchange reserves on cenral bank balance shees in he region over he pas decade. The overall size now lies a around 100% of GDP for Hong Kong and Singapore, and more han 30% of GDP for China, Korea, Malaysia, he Philippines and Thailand, and changes in foreign exchange reserves accoun for nearly all of he increase over he pas decade (Graph 4). Turning o he liabiliies side of he balance shee, only a small porion of he increase in foreign exchange reserves has been financed via an increase in he amoun of currency in circulaion (Graph 5). Insead, increased required reserves and he issuance of serilisaion insrumens have been used o effecively serilise he effecs of he increase in foreign exchange reserves, allowing policymakers o mainain domesic moneary conrol Jus as improved inflaion performance may lead o declining exchange rae pass-hrough (Devereux and Yeman 010), improved inflaion performance may encourage increased financial inernaionalisaion. Devereux e al (013) show ha a moneary policy rule which reduces inflaion variabiliy leads o an increase in he size of gross exernal posiions, boh in equiy and bond porfolios, consisen wih increased financial globalisaion. See he discussion in Filardo and Yeman (01). Aizenman and Glick (009), Cavoli and Rajan (006) and Ouyang and Rajan (011) also find ha serilisaion is close o complee in Asian economies. 7

10 Change in composiion of cenral bank asses in Asia, 00 1 As a percenage of change in oal asses Graph CN HK ID IN KR MY PH SG TH Foreign asses Claims on governmen and public enerprises Claims on privae secor Claims on banks Claims on oher financial secor eniies 0 CN = China; HK = Hong Kong SAR; ID = Indonesia; IN = India; KR = Korea; MY = Malaysia; PH = Philippines; SG = Singapore; TH = Thailand. Source: IMF Inernaional Financial Saisics. Change in composiion of cenral bank liabiliies in Asia, 00 1 As a percenage of change in oal liabiliies Graph CN HK ID IN KR MY PH SG TH Currency in circulaion Bank reserves a Cenral bank securiies b Governmen deposis Oher c 5 CN = China; HK = Hong Kong SAR; ID = Indonesia; IN = India; KR = Korea; MY = Malaysia; PH = Philippines; SG = Singapore; TH = Thailand. a Reserves and deposis of banks. ne iems) and equiy capial. b Cenral bank bonds and securiies. c Including oher liabiliies (foreign liabiliies, loans and oher Source: IMF Inernaional Financial Saisics. Going forward, one possibiliy would be for policymakers o coninue wih pas pracice, and offse any on-going exchange rae pressures wih inervenion. However, here are a leas wo reasons why his may be becoming a less aracive policy opion. Firs, as we have argued above, Asia is becoming more financially inernaionalised. Thus aemps o inervene in foreign exchange markes are increasingly likely o be offse by oher marke paricipans, so ha policy measures fail o have heir desired effec on exchange raes. Second, he already large holdings of foreign exchange reserves are very cosly o he cenral banks in he region, and are only likely o become more so if reserves grow larger, as would occur if appreciaion pressures remain dominan. 8

11 Table 1 illusraes he possible coss of large reserves under he simplifying assumpion ha all reserves are held in shor erm US reasury bills and are financed (or, equivalenly, serilised) via he sale of shor erm serilisaion bills wih an ineres cos equal o he domesic deposi rae. One cos componen is carrying (or serilisaion) coss. Typically, domesic ineres raes in Asia are higher han he yields earned on foreign exchange reserves. The difference beween hese wo is a loss o he cenral bank, and may be as much as 1.% of GDP per year for some economies. Anoher poenially cos is mark-o-marke losses from currency appreciaion; for illusraive purposes, he able considers a 10% appreciaion. The able also displays cenral bank equiy, again as a per cen of GDP, which is available o absorb hese losses. While a cenral bank can in principle coninue o operae wih low, or even negaive, capial, his is unlikely o be desirable in he long run. More imporanly, any loss on he cenral bank s balance shee ha resuls from excessive foreign exchange reserves may be viewed as represening a welfare loss o sociey An open economy model We now ouline a simple model consising of wo economies, home and foreign. While we conduc an essenially heoreical exercise, we inend i o inform he discussion and conduc of policy-making in he se of Asian economies discussed previously. In line wih his objecive, where possible we follow a model calibraion based on measuremens aken from previous DSGE models applied o Asian economies. The model is a sandard New Keynesian DSGE framework, wih a mixure of producer currency pricing and local currency pricing and home bias. 13 We add one new elemen o he model, mean o capure variaion in he degree of financial marke inegraion, based on Devereux and Yeman (014). This is represened by he following equaion: 14 * * C S P PY ( FR ) C P PC 1 1. () In his equaion represens he degree of inernaional financial inegraion. If 1, hen he equaion represens he usual sae-by-sae condiion for complee financial markes (perfec inernaional risk-sharing) and full financial inegraion. 15 If 0, hen here are no privae financial markes across economies a all and each economy consumes is income period-by-period, adjused for he change in he sock of foreign exchange reserves ( FR ). We can vary beween 0 and 1 o allow for an arbirary degree of financial marke inegraion and sudy he policy implicaions of increasing financial openness in Asian economies, in line wih he evidence on increased risk-sharing documened in Secion 3. Because foreign exchange reserves ener he model only hrough he second brackeed erm in condiion (), i is clear ha he effeciveness of foreign exchange reserves as a policy ool (i.e. serilised inervenion) will depend criically on he level of financial inernaionalisaion. In paricular, in he limi, as 1, a change in foreign exchange reserves will have no effec on exchange raes See also he discussion in Cook and Yeman (01). The model is similar o Engel (011, 013 and 014). For full model deails, see he appendix. Devereux and Yeman (014) show ha his condiion can be derived based on a ax on he financial reurns from invesing in (1 )/ foreign asses which akes he form (1 ) PC / ( PY ( FR )). Independenly, Caão and Chang (013) considered an equivalen funcional form (excluding a role for foreign exchange reserves) in heir invesigaion in he opimal moneary policy response o food prices. Here, C is home consumpion, C * is foreign consumpion, S is he nominal exchange rae, and P and P * represen he home and foreign CPIs. In addiion, P is he home GDP deflaor and Y is home GDP. 9

12 Esimaes of serilisaion coss and valuaion losses from currency appreciaion As of December 01 Table 1 FX reserves (USD billions) Shor-erm rae (%) Cenral bank equiy a,b 100% serilisaion cos a,c Valuaion loss for a 10% appreciaion of domesic currency (%) a China Hong Kong SAR India Indonesia d d 1.18 d Korea Malaysia Philippines Singapore Thailand a b As a percenage of nominal GDP. Provisions and oher liabiliies for SG; ne worh or own capial for ohers. Assumes enire FX reserve is invesed in 1 3 year US governmen bonds and he funding rae is he domesic deposi rae. d As of Sepember 01. Sources: IMF IFS; Bloomberg; Daasream; BIS calculaions. c We combine condiion () wih a sandard New Keynesian open-economy model wih he following feaures. We allow for home bias in consumpion. In paricular, le he home economy consumpion index be defined over home and foreign good consumpion as follows: / 1 / C ( C ) ( C ). (3) H The parameer capures he degree of openness o goods rade discussed in Secion 3: 1 corresponds o he absence of home bias, and o complee home bias such ha here is no overlap in he consumpion bundles of he wo economies. We also allow for a porion of impored goods o be priced in he consumers currency and he remainder in he producers currency, as in Berka e al (01). As we oulined in Secion 3, shor-run exchange rae pass-hrough appears o have declined in Asia, so ha he link beween exchange rae and inflaion changes has weakened. We model his analyically by assuming ha a greaer porion of impored goods are now priced in he consumers currency raher han he producers currency. 16 We allow he policymaker o respond o exchange rae changes in one of wo ways. Firs, we assume ha home economy ineres raes can respond o he change in he nominal exchange rae in addiion o CPI inflaion. One may hink of his as being a form of unserilised foreign exchange inervenion, since ineres raes are affeced by policy acions inended o influence exchange raes. Second, we allow policymakers o inervene direcly in foreign exchange markes by adjusing foreign exchange reserves in response o changes in he nominal exchange rae. This will direcly affec he soluion o equaion () above. We assume ha: F 1 ( FR) S / S. (4) 16 One limiaion of our wo-economy model is ha we canno incorporae vehicle currency pricing, discussed in Goldberg and Tille (008) and Cook and Devereux (006), whereby an economy sells goods o is rading parners priced in a hird economy s currency, for example when Asian economies rade wih each anoher based on US dollar pricing. 10

13 For 0, an appreciaion of he domesic currency precipiaes a build-up of foreign exchange reserves. Wih 1, his represens a policy of serilised inervenion since ineres raes are no direcly affeced by policy acions ha influence he exchange rae. There are few exising papers ha model serilised inervenion in a comparable manner. One excepion is Benes e al (013). 17 They also allow for wo differen moneary policy responses o exchange raes, including boh ineres rae responses and serilised foreign exchange inervenion. Bu heir modeling of he laer differs from ours: hey assume ha foreign exchange inervenion works hrough a porfolio balance effec o influence endogenous ineres rae spreads, and hence exchange raes. A number of papers look a he ineracion beween capial conrols and serilised inervenion. Prasad (013) shows ha capial conrols and serilised inervenion, used ogeher, can be welfare-improving by offering he cenral bank an addiional policy ool. The combinaion of hese wo ools allows auhoriies o effecively choose he level of foreign bond holdings. Since households do no ake accoun of he effec of heir foreign bond-buying decisions on prices, and he cenral bank can, he abiliy o conrol holdings of foreign bonds can be welfare enhancing. Bacchea e al (013) consider he opimaliy of capial conrols and he accumulaion of foreign exchange reserves. They show ha, if households face a borrowing consrain bu he auhoriies do no, one way o improve domesic welfare oucomes is o adjus ineres raes away from world levels, which requires he imposiion of capial conrols. Variaion in he level of foreign exchange reserves can also hen be used o influence he rade balance. In conras o hese papers, we ake he degree of financial inernaionalisaion (including he use or absence of capial conrols) as given and compare he effeciveness of serilised inervenion versus unserilised inervenion in pursui of policy goals. 18 We evaluae he welfare effecs of following differen moneary policy rules based on a second-order approximaion o he welfare funcion, in he spiri of Woodford (003). As in Engel (011), his welfare funcion depends on he oupu gaps (ha is, oupu relaive o where i would be if prices were flexible), inflaion raes and exchange rae misalignmens. As in almos all of he lieraure on opimal moneary policy in New Keynesian open economy models, we absrac away from sraegic consideraions o focus on he cooperaive policy ha maximises global welfare. A full exploraion of moneary policy in a noncooperaive framework involves considerable echnical and concepual difficulies and would ake us beyond he scope of he presen paper. For example, in a sraegic seing, he choice of sraegy space is imporan; here may be many equilibria, indexed by hreas or rigger sraegies; and each policymaker will ypically aemp o manipulae is erms of rade in is favour, inroducing an addiional disorion ino he analysis. 19 The full model and is log-linearisaion are oulined in he appendix. The model is quie sparse, relaive o some of he recen DSGE models used in he lieraure, bu, as we have noed above, i is designed o highligh hree key margins of srucural change in Asian economies. These are capured by he See, also, Osry e al (01) who consruc a reduced-form linear model where serilised inervenion and ineres raes are used o minimise a quadraic loss funcion in he oupu gap, inflaion, he exchange rae and he sock of reserves. An alernaive role for foreign exchange inervenion and he accumulaion of reserves, aside from he one ha we consider here, is o mainain an undervalued exchange rae o spur higher raes of economic growh. For example, Korinek and Servén (009) show how an undervalued exchange rae, which raises he price of radable goods relaive o non-radables, may be desirable if he radable secor is more capial inensive if here are sufficien learning-by-doing exernaliies in he economy. For examples of papers ha examine sraegic consideraions in more resricive environmens han ours, see Benigno and Benigno (006) who derive he welfare approximaions in a wo economy seing wih producer currency pricing and complee financial markes, bu do no solve for he non-cooperaive opimal moneary policies. Clarida, Gali and Gerler (00) solve a simpler problem where opimal subsidies are in place o offse he erms of rade disorion, assuming complee financial markes. Cook and Devereux (013) employ an exended version of he Clarida, Gali and Gerler specificaion o solve a noncooperaive policy problem in a zero-bound environmen where only one policy-maker is choosing moneary policy opimally. 11

14 parameers, and, for he degree of financial inegraion, goods marke inegraion and shor run exchange rae pass-hrough ino consumer prices respecively. From he esimaes given in Graph 3, i is clear ha he appropriae value for is beween 0 and 1 and declining; we explore he impac of variaions in on opimal policy below. The higher is he parameer, he more he economy is closed o inernaional rade, wih 1 capuring complee openness. For he nine major Asian economies discussed in Secion, he median expors/gdp raio is increasing and was 0.58 in 01. Taken lierally, his would correspond o a parameer less han uniy in a symmeric seady sae (since expors/gdp will be (1 / ) in his case). Bu measured expors include a lo of inermediae goods, so 1 is likely o be he more relevan empirical case. Finally, he closer is o uniy, he lower is he value of shor-run pass-hrough. The esimaes in Graph 1 would imply a very high value of. Noe, however, ha only capures he immediae impac effec of exchange rae pass-hrough, while he full dynamics of pass-hrough in he model are capured by he shock process and he degree of price rigidiy. We also consider wo shocks, produciviy and markup shocks, wih parameerisaions ha are similar o hose in he lieraure ha has employed DSGE modelling for Asian economies (e.g. Wong e al 014). The degree of price adjusmen follows a Calvo-ype specificaion, and again is calibraed along lines used in previous applicaions for Asia. A full se of variable and parameer names, descripions and calibraed parameer values is given in Table. 5. Resuls We now examine he resuls of our model, focusing on how serilised or unserilised foreign exchange inervenion can be used o improve welfare. We compue he maximum achievable level of global welfare under four differen assumpions abou how moneary policy is se. Firs, moneary policy is characerised by a simple Taylor-ype rule, where ineres raes in boh economies respond linearly o domesic CPI inflaion (labelled Taylor in he graphs ha follow). Second, moneary policy is characerised by a Taylor-ype rule, bu where ineres raes in he home economy also respond o he change in he nominal exchange rae ( Taylor + unserilised ). Third, moneary policy is characerised by a Taylor-ype rule in inflaion in boh economies, bu he home moneary auhoriy can also use serilised inervenion, where he change in foreign exchange reserves is a linear funcion of he change in he nominal exchange rae in log erms ( Taylor + serilised ). Finally, we also compue he opimal Ramsey oucome, where he responses of ineres raes in boh economies, and he change in foreign exchange reserves in he home economy, are chosen so as o maximise global welfare, as a reference poin agains which o compare he oher resuls. 0 We consider produciviy shocks and cos-push shocks in urn. In each case, boh economies are subjec o independen shocks ha have AR(1) persisence coefficiens of 0.9. We hen examine he relaive performance of he differen moneary policy regimes across hree differen dimensions: Varying he degree of inernaional risk-sharing, or financial inernaionalisaion, as capured by he parameer ; Varying he degree of shor-run exchange rae pass-hrough, as capured by he parameer ; Varying he degree of goods marke inegraion, capured by he parameer. 0 The firs hree of hese are solved using he opimal simple rules rouine in Dynare, and he final one using he Ramsey policy rouine. 1

15 Variables and parameers Table Names Descripion Name Descripion Value c Consumpion Inverse of elasiciy of iner-emporal subsiuion.0 p Price level Home bias in consumpion 1- s Nominal exchange rae Elasiciy of subsiuion beween differen varieies of home (foreign) goods 11.0 y Oupu Share of impors ha are LCP (remainder are PCP) 0-1 Terms of rade Degree of financial inernaionalisaion 0-1 Deviaion from law of one price Response of foreign exchange reserves o nominal exchange rae changes 0- fr Foreign exchange reserves Discoun rae 0.99 u Cos-push shock Degree of price sickiness a Produciviy shock Elasiciy of labour supply 1.0 V Ineres rae response o inflaion 0- Home ineres rae response o he change in exchange raes 0- Graph 6 illusraes he effeciveness of differen policy rules in achieving opimal welfare in response o produciviy shocks. The horizonal axis is he proporion of impors ha are priced in he local currency,. The lef-hand panel is under financial auarky ( 0 ), and he righ-hand panel wih complee financial inernaionalisaion ( 1). In-beween levels of financial inernaionalisaion are qualiaively similar o he auarky case. In his exercise, here is some home-bias in consumpion ( 1.5 ). Noe ha all welfare levels are relaive o he Ramsey oucome: a welfare level of zero indicaes ha welfare is he same as would resul from he Ramsey policy. Wih less-han-complee financial inernaionalisaion, a combinaion of serilised inervenion and following a simple Taylor rule, where he coefficien is chosen opimally, comes closes o achieving he opimal Ramsey oucome. However, here is lile subsiuabiliy beween serilised and unserilised inervenion. This is because any improvemen in oucomes wih unserilised inervenion is he resul of a rade-off: a single policy insrumen (ineres raes) is being used o respond o an addiional variable. In welfare erms, ha rade-off is barely worh making: he pahs of all nominal and real variables are lile changed wheher he cenral bank responds only o inflaion or o boh inflaion and exchange rae changes opimally. In conras, serilised inervenion represens an addiional policy ool ha does no compromise he ineres rae response o inflaion. We can see hese effecs by looking a he impulse responses. Graph 7 oulines he responses o a domesic produciviy shock wih financial auarky, home bias and a mixure of local currency and producer currency pricing. Three differen policy rules are considered, corresponding o each of he opimal policy rule parameers displayed in he previous graph. A home economy produciviy shock is deflaionary for he home economy. The opimal Taylor rule response is a reducion in policy raes, which leads o an exchange rae depreciaion, and a corresponding reducion in he price of he home good for foreign consumers. Effecively, he behaviour of he exchange rae here is helping o compensae for he lack of inernaional risk sharing. Households in he foreign economy do no hold home-economy asses, so he only way hey can share in he 13

16 benefis of a home-economy produciviy shock is if he price of home-economy goods falls. Hence a deviaion in he law of one price can be consisen wih maximising global welfare in a world in which moneary policy is consrained o follow a Taylor rule. effecs of produciviy shocks Home bias (=1.5) Graph 6 Financially closed (λ=0.0) Financially open (λ=1.0) Porion of impors priced in local currency Taylor Taylor + serilised All oucomes are relaive o he Ramsey policy. Porion of impors priced in local currency Taylor + unserilised Impulse responses o domesic produciviy shock λ=0.0, δ=0.5, υ=1.5 Graph 7 y y* c c* τ s s(-1) π Taylor Taylor + serilised Taylor + unserilised

17 Amending he ineres rae rule o allow for an opimal linear policy response o exchange rae changes (in log erms), in addiion o he response o domesic inflaion, allows for a more precisely calibraed policy response along he same lines. The response o he exchange rae enails a sharp reducion in policy raes, sufficien o fuel a low level of inflaion in he domesic economy on impac and increase he deviaion from he law of one price. Qualiaively, he consumpion pah across he wo economies is more alike wih his more complex rule. Including serilised inervenion insead, we can see ha he use of his new, independen, policy insrumen compleely changes he responses of he economy under opimal policymaking. The cenral bank now responds very srongly o domesic inflaion using ineres raes and o he exchange rae using serilised inervenion. The resul is ha he response of exchange raes and prices (and herefore also deviaions from he law of one price) are all effecively eliminaed. However, whereas consumpion increased in boh economies in response o a posiive domesic economy produciviy shock before, now consumpion in he foreign economy acually declines on impac. To undersand how his can represen an opimal policy response, iniial consumpion falls, bu long-erm consumpion rises. Combining hese, he discouned lifeime welfare for foreign consumers is only slighly lower using serilised inervenion han wih only a Taylor rule response. And, from he perspecive of global welfare, his is more han offse by he gain o domesic economy consumers, who now see a larger increase in consumpion in response o he produciviy shock. The availabiliy of serilised inervenion gives moneary auhoriies an addiional policy ool ha is no available in he fully inegraed financial markes case. I effecively allows for income or wealh ransfers across economies in response o shocks in ways ha can assis he goal of overall sabilisaion policy. In he case of Graph 7, in he absence of serilised inervenion, he home economy produciviy shock will generae a erms-of-rade deerioraion, and a persisen increase in home oupu relaive o foreign oupu. For a given response of he world oupu gap, i is inefficien o have he home oupu gap differ from he foreign oupu gap. Serilised inervenion can correc his, by generaing a reversal in he response of he erms of rade, and a fall in foreign consumpion. The join effec of boh of hese movemens is o mainain a higher level of foreign oupu. A he same ime, serilised inervenion acs so as o limi he response of he nominal exchange rae o he shock and, by doing so, reduces he inefficiencies associaed wih deviaions from he law of one price. In a world of complee financial inegraion (Graph 6, righ panel), serilised inervenion is no longer effecive. Insead, he only avenue for policymakers o influence he exchange rae is hrough unserilised inervenion. Then hey canno ge as close o Ramsey oucome, condiional on he level of financial inernaionalisaion. Graph 8 repeas he same exercise as in Graph 6, bu wih he degree of shor-run exchange rae passhrough fixed such ha half of impors are priced in he producer currency, and half in he local currency ( 0.5 ). Insead, he degree of goods marke inegraion is varied from 1.9 (goods markes are almos closed) o 1.0 (no home bias in consumpion). The horizonal axis goods marke inegraion is defined as ( ) so ha a higher number corresponds wih greaer inegraion. All welfare measures are again relaive o hose under he Ramsey policy. Noe ha he levels of welfare across differen values of goods marke inegraion are no direcly comparable, since is a preference parameer. Insead, he purpose of he exercise is o focus on he relaive performance of he differen policy measures a given levels of goods marke inegraion. Wih high levels of home bias serilised inervenion is an especially poen ool for achieving close o he firs-bes oucome. Wihou serilised inervenion, a posiive domesic produciviy shock would cause he domesic currency and erms of rade o depreciae, disoring consumpion decisions. Serilised inervenion can be used o preven his. 15

18 effecs of produciviy shocks Mixure of local and producer currency pricing (=0.5) a Graph 8 Financially closed (λ=0.0) Financially open (λ=1.0) Goods marke inegraion b Taylor Taylor + serilised Taylor + unserilised Goods marke inegraion b 0.08 a Half of all impor varieies are assumed o be priced in he local currency and half in he producer currency. is defined as - b Goods marke inegraion The effeciveness of serilised (and unserilised) inervenion in response o produciviy shocks relies on some degree of home bias. In he limi of no home bias in consumpion, provided he moneary policy response o inflaion is opimal, here are no gains o inervening in foreign exchange markes in response o produciviy shocks. (This is rue independen of he degree of exchange rae pass-hrough and financial inernaionalisaion). The opimal response o inflaion via he Taylor rule is sufficien o fully sabilise inflaion and, when consumers in boh economies have idenical preferences over boh home and foreign goods, also fully sabilise he nominal exchange rae. Given ha inflaion and he exchange rae are fully sabilised, deviaions from he law of one price and he welfare coss of nominal rigidiies are enirely eliminaed. Effecively, goods marke inegraion serves as a means of risk sharing in response o produciviy shocks; in he limi of complee goods marke inegraion, i emulaes complee risk-sharing. Hence, wih complee goods marke inegraion, here are no gains o a moneary policy rule ha enails a response o he exchange rae over one ha simply responds o inflaion. More generally, if goods markes are no fully inegraed, hen even if inflaion in boh economies is sabilised, he price of impored goods will end o behave differenly from he price of domesically produced goods, and he exchange rae will vary in response o produciviy shocks. In ha case, serilised inervenion can be effecive. In he following wo graphs we repea he analysis for a cos-push shock, across he same dimensions as above. The resuls are broadly similar. One ineresing oucome across all our resuls is he relaive unimporance of he degree of financial inernaionalisaion. Visually, for all levels of 1, he graphs look similar o he financially closed ( 0 ) case presened in he lef-hand panels of he graphs above. As increases, provided i remains below 1.0, here is lile impac on achievable welfare. Bu once we move o a world of perfec financial inernaionalisaion, hen, by consrucion, serilised inervenion no longer plays a role. One limiaion in his inerpreaion of our resuls is ha we do no capure he poenial coss of volaile reserves in our model. As he level of financial inernaionalisaion increases, bu remains incomplee, cenral banks are able o achieve exacly he same oucome wih ever increasing foreign exchange inervenion. Bu his implies ha he volailiy of foreign exchange reserves is increasing in he level of financial inernaionalisaion. Clearly policymakers ascribe a negaive welfare impac o highly volaile foreign exchange reserves. More volaile reserves implies an increased likelihood of exremely high levels of reserves, leading o increased 16

19 risks on he cenral bank s balance shee and high serilisaion coss as discussed in Secion 3, or compleely running ou of reserves and having no choice bu o change he moneary policy regime. While explicily modelling he cos of volaile reserves is beyond he scope of his paper, we address his issue by adding an addiional erm o he welfare funcion of ( fr fr 1), in log erms, wih a weigh of negaive one. In Graph 11 we presen analogous resuls o hose presened previously in Graph 6 for a range of levels of financial inernaionalisaion, bu incorporaing his negaive welfare effec of foreign reserves volailiy. This has he inuiive effec of lowering he gains available from pursuing serilised inervenion, such ha unserilised inervenion dominaes serilised inervenion long before he economies are fully financially inernaionalised. 1 effecs of cos-push shocks Home bias (=1.5) Graph 9 Financially closed (λ=0.0) Financially open (λ=1.0) Porion of impors priced in local currency Taylor Taylor + serilised Porion of impors priced in local currency Taylor + unserilised 18 effecs of cos-push shocks Mixure of local and producer currency pricing (=0.5) a Graph 10 Financially closed (λ=0.0) Financially open (λ=1.0) Goods marke inegraion b Taylor Taylor + serilised Taylor + unserilised Goods marke inegraion b a Half of all impor varieies are assumed o be priced in he local currency and half in he producer currency. is defined as - b Goods marke inegraion 1 For an analogous graph wih cos-push shocks wih cosly foreign exchange reserves volailiy, please see he appendix. 17

20 effecs of produciviy shocks wih cosly reserves volailiy Home bias (=1.5) Graph 11 λ=0.0 λ= Porion of impors priced in local currency Porion of impors priced in local currency λ=0.50 λ= Porion of impors priced in local currency Taylor Taylor + serilised Porion of impors priced in local currency Taylor + unserilised Conclusions We have examined how moneary policy should respond o nominal exchange rae changes, wih he hope of helping o inform he debae over he evoluion of Asian moneary policy. We have shown how he opimal response o exchange raes depends on he degree of financial inernaionalisaion, goods marke inegraion and exchange rae pass-hrough. Serilised inervenion can be a poen ool ha offers policymakers an addiional degree of freedom in maximising global welfare. The poenial welfare benefis from serilised inervenion are larges in our model if exchange rae pass-hrough is high or goods markes are poorly inegraed, and in response o produciviy shocks (less so wih cos-push shocks). However, as he inernaional policy rilemma implies, our model suggess ha here are limiaions o he use of serilised inervenion. As financial inernaionalisaion increases, achieving a given degree of exchange rae sabiliy requires ever increasing changes in foreign exchange reserves. Taking ino accoun he cos of volaile reserves, increased financial inegraion reduces he role for serilised inervenion. In he case of fully inegraed inernaional financial markes, serilised inervenion has no influence on exchange raes a all. Where serilised inervenion is no longer a desirable policy ool, unserilised inervenion may have a role o play. However, he poenial welfare gains from he opimal use of his ool in our model are relaively small. Wih unserilised inervenion, a single policy insrumen (ineres raes) is effecively being used o respond o an addiional variable (exchange raes), compromising is response o inflaion. In conras, serilised inervenion represens an addiional policy ool ha does no impinge on he opimal ineres rae response o oher variables. 18

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