A Quantitative Model for the Integrated Policy Framework

Many emerging market economies moved off fixed exchange rates to inflation targeting over the past two decades, yet unlike advanced economies they kept intervening in foreign exchange markets and, in some cases, using capital flow management tools. This paper builds an empirically-oriented New Keynesian small open economy model – “similar to those widely used by central banks” – to quantify when that behaviour improves policy tradeoffs. It extends Galí and Monacelli (2005) along four dimensions: a broader set of real and nominal rigidities, including habit persistence, sticky wages and prices, and imperfect exchange rate passthrough with local currency pricing as the benchmark (producer and dominant currency pricing are also available); adaptive inflation expectations for some agents, capturing imperfect monetary policy credibility; incomplete markets, so domestic agents must borrow in a foreign currency bond rather than share risk fully; and Gabaix (2016) discounting in the Euler, UIP and price-setting equations, which mitigates the forward guidance puzzle. Onto this largely log-linear core the authors graft three nonlinearities: a UIP risk premium that rises sharply once net foreign liabilities pass a risk-tolerance-dependent threshold, a private borrowing spread that rises nonlinearly as the currency depreciates (following Bruno and Shin, 2018), and an effective lower bound on the policy rate. Calibration is quarterly and, apart from the balance sheet channels, identical across country types with one exception – the price and wage formation parameters, set to 0.75 structural persistence with steeper Phillips slopes for the emerging market against 0.5 and 0 with flatter slopes for the advanced economy. The linear results establish the tradeoff. A UIP risk premium shock (AR(1) of 0.9, scaled to depreciate the advanced economy’s real exchange rate by 10 percent) “looks very similar to a ‘standard’ aggregate demand shock” in the advanced economy, where policy can look through a transient inflation rise; in the emerging market the same shock raises inflation persistently, forcing real rates up and crowding out domestic demand, so output contracts slightly while inflation rises substantially. Policy cannot resolve this within the rate instrument alone: a more aggressive inflation-stabilisation rule limits the inflation rise but produces “a sharper output contraction of about 1.5 percent.” The nonlinear results establish where the extra tools help most. In a crisis scenario combining a risk tolerance decline (AR(1) of 0.85, half-life about five quarters) with falling foreign demand, a high-net-foreign-liability economy suffers a real depreciation several times larger and a considerably bigger output contraction than a low-liability one, and either FX sales or an outflow tax limits the depreciation, allows easier policy, and damps the borrowing spread – allaying what the authors call the “stagflationary” effect. But the relief is intertemporal: by supporting the currency, both tools slow the trade balance improvement, so net foreign liabilities end up higher and the UIP premium eventually runs above baseline, and the appeal “is somewhat diminished… as the shock becomes more protracted.” Stochastic simulations over 20,000 periods show the nonlinearities generating a left skew in domestic absorption reaching about -15 percent and in the output gap about -10 percent, and systematic FXI and CFM rules “markedly reduce the likelihood of large real exchange rate depreciations” and the associated tail risk of a large output contraction. A final exercise applies the linear advanced economy model to a liquidity trap where output falls over 10 percent below baseline and the policy rate is pinned at zero, and finds FX purchases keep core CPI inflation much closer to its 2 percent target – Svensson’s “foolproof way.” The authors are unusually direct about the limits of all of this: “our model results should not be taken as an unqualified endorsement of the use of these tools either in general or in specific situations,” since the model assumes perfect foresight while real decisions are made under uncertainty, and since stabilising the exchange rate “may impede the development of hedging markets, and encourage an excessive buildup of foreign currency debt.” A title-page disclaimer records that the document “was prepared before COVID-19 became a global pandemic and resulted in unprecedented economic strains” and “does not reflect the implications of these developments and related policy priorities” – worth carrying, since the paper’s policy discussion predates the episode that most tested its subject matter.

Jianping Zhou | Macro Paper Warehouse

A Quantitative Model for the Integrated Policy Framework