Financial Fragility, Regime Switching and Monetary Policy - With Application to Emerging Markets

Abstract

The experience of the Asian currency and financial crisis in the years 1997-8 encouraged economists to develop some open economy nonlinear macro models. Such models allow for nonlinearities – studying the effects of contractionary currency devaluation in contrast to the standard model of expansionary currency devaluation. One in particular can distinguish here between slow and fast moving risk premia and exchange rates. As shown currency depreciation and slow moving exchange rates and risk premia may render the economy expansionary whereas fast moving exchange rates (fast depreciation) and fast increase in risk premia may generate macroeconomic instability and contractions. This is of course impacted by monetary policy that recently has moved from conventional (interest setting) to unconventional (asset purchasing) policies. The latter was in particular aiming at asset prices and risk premia, namely to bring risk premia of private assets (stocks and bonds) down and reduce credit spread for private and public bond yields. By doing this central banks are de-risking assets to stimulate aggregate demand (Caballero et al. 2020). But the latter policy has produced also international tensions due to spillover and volatility effects to other countries. In a generic nonlinear dynamic model of the finance-macro link we include the dynamics of the inflation rates, output gap and financial variable such as credit flows, risk premia and exchange rates. In the empirical part of the paper we examine then the interaction between the real and financial sectors of emerging market economies in particular post the financial crisis 2008-9. Though the dynamic model is operating with both the output gap and credit gap in our empirical analysis we work with the output gap only, since credit flows are hard to obtain for the large number of EM countries we study. Looking at a two-regime output gap and some financial indicators – such as risk premia, banking beta, and exchange rates – we then adopt the non-linear logistic vector smooth transition autoregressive (LVSTAR) approach of Schleer and Semmler (2015) with a logistic type transition function governing the LVSTAR system. Our study reveals that financial indicators of emerging economies show different responses to external shocks. With a positive shock in risk premia, the exchange rate depreciations occur in most emerging economies, and more so if the country faces a negative output gap.