The growth of emerging economies and global macroeconomic stability

The growth of emerging economies and global macroeconomic stability

Vincenzo Quadrini

University of Southern California

June 21, 2015

0 0.2 0.4 0.6 0.8 1 1.2

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013

GDP of Emerging Countries Relative to

Industrialized Countries

At Parchasing Power Parity At Nominal Exchange Rates

‐0.3

‐0.2

‐0.1 0.0 0.1 0.2 0.3

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Net Foreign Position in Debt and  Reserves 

(Percent of GDP)

Emerging Countries Industrialized Countries

QUESTION

How does the growth of emerging economies affect the financial and macroeconomic stability of both emerging and industrialized countries?

ADDRESSING THE QUESTION

1. I develop a two-country model where global banks play a central role.

2. Emerging countries have a greater demand for financial assets.

3. The model generates financial crises induced by self-fulfilling expectations about the liquidity of the banking sector.

4. I then use the model to study how the growth of Emerging Economies affects macroeconomic stability.

PREVIEW OF RESULTS

• The increased size of emerging countries increases the world demand for liquid assets (bank liabilities in the model).

• This reduces the interest rate paid by banks and creates an incentive for banks to leverage.

• The higher leverage increases financial fragility: higher probability of a crisis and/or the macroeconomic consequences of a crisis.

THREE SECTORS MODEL

1. Entrepreneurial sector

2. Worker sector

3. Financial intermediation sector

1. Entrepreneurial sector

• Continuum of entrepreneurs with utility E₀ P∞

t=0 β^t ln(cⁱ_t)

• Technology F(z_tⁱ, hⁱ_t) = z_tⁱhⁱ_t hⁱ_t = Input of labor

z_tⁱ = Idiosyncratic shock observed after choosing hⁱ_t.

• They can buy bonds bⁱ_t+1. The budget constraint is

cⁱ_t + bⁱ_t+1

R_t^b = (z_tⁱ − w_t)hⁱ_t + bⁱ_t ≡ aⁱ_t

Optimal entrepreneur’s policy

hⁱ_t = φ(w_t)bⁱ_t

cⁱ_t = (1 − β)aⁱ_t

bⁱ_t+1

R^b_t = βaⁱ_t

Where φ_t satisfies E^z

n z−w_t 1+(z−w_t)φ_t

o

= 0.

Aggregate demand of labor H

_t

= φ(w

_t

)

Z

i

b

ⁱ_t

|{z}

Financial wealth

6

H_t

Aggregate demand of labor H

_t

= φ(w

_t

)

Z

i

b

ⁱ_t

|{z}

Financial wealth

- 6

w_t H_t

2. Worker sector

• Continuum of workers with utility E⁰ P∞ t=0 β^t

c_t − αz¯_t^h

1+ν t

1+ν

• They hold a non-reproducible asset in fixed supply K, traded at price p_t. Each unit produces χz¯_t units of consumption goods.

• They can borrow subject to the collateral constraint l_t+1

R^l_t ≤ ηE^tp_t+1k_t+1

• Budget constraint

c_t + l_t + (k_t+1 − k_t)p_t = l_t+1

R^l_t + w_th_t + χz¯_tk_t

First order conditions for workers

αh^ν_t = w_t

1 = βR_t^l(1 + µ_t)

p_t = βE^t h

χ + (1 + ηµ_t)p_t+1i

Aggregate supply of labor H

_t

=

^w_α^t

_ν¹

- 6

w_t H_t

EQUILIBRIUM

WITHOUT INTERMEDIATION

(Borrowing and lending is direct)

LABOR MARKET EQUILIBRIUM

- 6

w_t

H_t Labor supply

H_t^S = ^wt_{α ν}¹

Labor demand H_t^D = φ(w_t)B_t

LABOR MARKET EQUILIBRIUM (Lower stock of bank liabilities)

- 6

w_t

H_t Labor supply

H_t^S = ^wt_{α ν}¹

Labor demand H_t^D = φ(w_t)B_t

INTRODUCING

THE INTERMEDIATION SECTOR

Schematic overview of the economy

Financial Intermediaries

Net borrowers (Workers) Net savers

(Entrepreneurs/

producers)

Consumption Labor supply Consumption

Hiring

3. Intermediation sector

• Banks start with liabilities b_t and loans l_t.

• The liquidation value of bank assets is ξ_tl_t, with ξ_t ∈ n

ξ,1o .

• Banks renegotiate if liabilities exceed the liquidation value of assets,

˜b_t(b_t, l_t) =

b_t, if b_t ≤ ξ_tl_t ξ_tl_t if b_t > ξ_tl_t

• There is an intermediation cost that rises with leverage.

˜

ϕ_t(b_t+1, l_t+1) = ϕ

b_t+1

l_t+1 − ξ

b_t+1

LOW LEVERAGE (No default)

l_t ξ l_t

6

b_t

HIGH LEVERAGE (Possibility of default)

l_t ξ l_t

6

b_t

Bank’s problem

V_t(b_t, l_t) = max

d_t,b_t+1,l_t+1

(

d_t + βE_tV_t+1(b_t+1, l_t+1) )

subject to

˜b_t(b_t, l_t) + ϕ˜_t(b_t+1, l_t+1) + l_t+1

R_t + d_t = l_t + E^t˜b_t+1(b_t+1, l_t+1) R^b_t

First order conditions

1

R^b_t = β h

1 + Φ_b

t+1

l_t+1

i

1

R^l_t = β h

1 + Ψ_b

t+1

l_t+1

i

Two-countries:

The growth of emerging economies

and global imbalance

Cross-country heterogeneity

1. Differences in size:

• Productivity, z¯_j

2. Differences in financial market characteristics:

• Volatility of the idiosyncratic shock, σ_j

• Borrowing limit, η_j

SIMULATION EXERCISE

• Country 1: Industrialized economies. Country 2: Emerging economies.

• Relative productivity ^z_z^¯_¯²

1 changes over the period 1991-2013.

• Model simulation repeated 1,000 times. In each simulation:

– Same sequence ^z_z^¯_¯²

1;

– Different sequences of random draws ξ.

CALIBRATION

(Based on early 1990s data)

• Quarterly model with β = 0.985.

• Working dis-utility parameter α_j to have average labor equal to average employment over population.

• Output from fixed asset χ to match share of housing services in GDP Housing service share = χ

H_j,t + χ

• Collateral parameter η_j to generate private credit to GDP in each country.

• Volatility of idiosyncratic shock σ₁ = [0.7,1.3], σ₂ = [0.4,1.6].

CALIBRATION

(Based on early 1990s data)

• Low realization of shock ξ = 0.85.

• Intermediation cost

ϕ(ω_t+1) = τ +







0, if ω_t+1 ≤ ξ (ω_t+1 − ξ)², if ω_t+1 > ξ

.

Parameter τ chosen to target the share of finance in GDP.

Calibration of relative productivity (Based on 1991-2013 data)

GDP_2,t

GDP_1,t = z¯_2,t

¯ z_1,t

H_2,t + χ H_1,t + χ

.

REPEATED SIMULATIONS

REPEATED SIMULATIONS

FOR A PARTICULAR SEQUENCE OF SHOCKS

• From 1991 to third quarter of 2008 the realization of the shock is HIGH.

• In the fourth quarter of 2008 the realization of the sunspot shock is LOW.

• Afterwards, the realization of the sunspot shock is HIGH.

SPECIAL SIMULATION

SPECIAL SIMULATION

CONCLUSION

• Cheap funding for banks creates an incentive to leverage.

• More leverage exposes the banking sector to crises.

• The growth of emerging economies pushes the globalized economy in this direction raising financial and macroeconomic instability.