Depreciation Shocks Research Articles

Green transition and financial stability: The role of green monetary and macroprudential policies and vouchers

This paper analyzes a mix of alternative policies in supporting the green transition and the phase-out of fossil fuels, without compromising financial stability. An environmental dynamic stochastic general equilibrium (E-DSGE) model with two sectors (green and brown) and endogenous default is developed to assess potential climate-induced financial stability threats that can be mainly generated through physical and transition risks mechanism. Those risks are evaluated through a compound capital depreciation shock and a carbon tax shock. The paper offers several findings. First of all, a too stringent carbon tax would increase the medium-term default rate in both sectors, harming financial stability due to potentially detrimental effects on banks’ balance sheet. Second, there exists a trade-off in implementing green monetary or macroprudential policies: if a policy can encourage the green transition, financial stability is compromised due to a rise in default rates. In contrast, if a policy aims to reduce vulnerabilities and financial stability risks, then the phase-out of the polluting sector to foster the green sector would be hard to achieve. The model finds that under certain physical and transition risks, a dual interest rate policy, coupled with a fiscal policy in which carbon tax revenues are redistributed to households as vouchers to encourage the consumption of green goods, is able to support the green transition and safeguard financial stability. Therefore, top-down and bottom-up approaches are the keys for sustainability in the whole economy and financial system.

The macroeconomic effects of exchange rate movements in a commodity-exporting developing economy

This paper empirically examines the macroeconomic effects of exchange rate movements and their transmission mechanisms (trade and financial channels) in Mongolia, a net debtor in foreign currency and a commodity-exporting developing economy, using Structural Bayesian Vector Autoregression (SBVAR) models. Our findings suggest that both the financial and trade channels of exchange rates are operative and have a notable impact at the macroeconomic level. We identify a significant financial channel, causing GDP contractions and affecting investments, particularly in sensitive sectors such as manufacturing and construction in response to DWER depreciation shocks. The traditional trade channel, driven by NEER depreciation, leads to increased net exports with pass-through to CPI. Despite these effects on key macro variables, exchange rate shocks do not substantially destabilize the economy. Foreign shocks, including federal funds rates, China's GDP, and copper prices, have a more pronounced impact. The trade channel plays a crucial role in the transmission of external demand and commodity price shocks, while the financial channel is essential in the transmission of commodity price shocks.

Does exchange rate volatility affect the impact of appreciation and depreciation on the trade balance? A nonlinear bivariate approach

Does exchange rate volatility alter the effect of appreciation and depreciation on the trade balance? The literature posits that the trade balance responds more to depreciation shocks than appreciation shocks. Using monthly data from 1960M02–2020M12, we examine the asymmetric effects of exchange rates on the trade balance while accounting for exchange rate volatility. The study applies a nonlinear bivariate model that allows asymmetric effects and volatility to be examined concurrently. We find that exchange rate volatility reduces the positive effects of an appreciation shock on the trade balance in developed countries in the short and long run. In developing nations, exchange rate volatility promotes the positive effects of a depreciation shock on the trade balance, both in the short and long run. The transmission mechanism implies that a depreciation shock is ineffective in developed countries because the volatility that accompanies the shock diminishes the trade balance.

Asymmetric Exchange Rate Pass Through to Consumer Prices: Evidence from Zambia

The purpose of this study was to examine the asymmetric exchange rate pass through (ERPT) to consumer price inflation in Zambia. We examined ERPT to consumer price inflation arising from kwacha depreciation and appreciation for the period between the first quarter of 1985 to the fourth quarter of 2017. We employed the structural vector autoregressive model. The results showed that ERPT to consumer price inflation is incomplete and asymmetric. Consumer prices in Zambia are more responsive to kwacha depreciation than to appreciation. The depreciation of the kwacha has a greater significant impact on consumer prices than the appreciation of the kwacha. The impulse response function analysis showed that the shock to kwacha depreciation is very persistent than that of kwacha appreciation. Finally, the forecast error variance decomposition showed that a depreciation shock explains a bigger portion of the variance in consumer price inflation than an appreciation shock. These findings show that kwacha depreciation and appreciation have different effects on consumer price inflation, thereby confirming the presence of asymmetries in the ERPT. The study also accounted for the effect of commodity price booms in influencing ERPT. However, results of ERPT did not change much with the inclusion of commodity price booms. JEL Codes: E31, F31

Central Bank Intervention in the Inflation Targeting

Abstract This paper analyses the impact of central bank interventions in the inflation targeting regime. The results of empirical studies in this paper show if there is a shock of the exchange rate, which would lead to depreciation of the exchange rate, a central bank may decide to mush instability on the foreign exchange market with foreign exchange interventions, thereby preventing the sudden exchange rate depreciation, which would then require a smaller reaction by the interest rate. Namely, through foreign exchange interventions, the central bank greatly absorbs the depreciation shock and, consequently, inflation is lower. As a result of lower price growth, the need for a monetary policy response to an interest rate is also lower. Based on this example, we can see that central bank intervention in some cases can be very useful in order to correct disturbances in the foreign exchange market. Therefore, some central banks accumulate foreign exchange reserves at a very high level so as to have enough space for foreign exchange intervention, without the risk of falling foreign exchange reserves below the optimum level.

Dynamics of the real exchange rate in European emerging economies: Evidence from quantile regression

The sustainability of purchasing power parity (PPP) theory is examined within the quantile autoregression model for the monthly data of the euro and the US dollar-based real exchange rate (RER) in selected European economies (the Czech Republic, Hungary, Poland, Romania, Serbia and Turkey). Period from January 2000 to December 2014 is covered. The application of quantile autoregression model is motivated by the necessity of identifying asymmetric behavior of the RER due to the shocks of different size and sign. The empirical results support to some extent the PPP theory for the euro- and US dollar-based RER in Romania, Serbia, and Turkey. The euro-based RER in Hungary and Poland is also identified to confirm the PPP theory. The dynamics of the RER in the Czech Republic cannot be associated with the PPP validity. The persistence of the euro-based RER is estimated to be more prominent after the depreciation shocks of smaller size.

Valuing Government Obligations When Markets Are Incomplete

AbstractWe simulate a 10‐period overlapping generations model with aggregate shocks to price safe and risky government obligations using consumption‐asset pricing. Agents cannot trade with future generations to hedge the model's productivity and depreciation shocks, and can only invest in one‐period bonds and risky capital. We find that the pricing of short‐ and long‐dated riskless obligations is anchored to the prevailing risk‐free return. The prices of obligations whose values are proportional to the prevailing wage are essentially identical to those of safe obligations, notwithstanding large macro shocks. On the contrary, government obligations in the form of options entail significant risk adjustment.

Assessing the effects of exchange rate depreciation on the US economy

PurposeThe purpose of this paper is to examine the effects of exchange rate shock on the broad spectrum of the US economy using a factor-augmented VAR model (FAVAR).Design/methodology/approachThe authors developed a two-factor FAVAR model and estimated it with the single-step Bayesian likelihood approach using the Gibbs sampling technique. The two factors represented, respectively, the economic activity and price pressures. The exchange rate shock was identified with the Choleski decomposition method for VARs. The authors used the data of 117 time series for the period from 1973:02 to 2007:12. Impulse responses and variance decompositions were computed as the main results.FindingsThe authors found that exchange rate shock has pervasive effects on the US economy as the following: depreciation does not appear to help reduce the US trade deficit as both import and export rise with the depreciation shock; in the short run, depreciation appears expansionary as industrial production, manufacturing and employment all increase within a year; in the medium run, depreciation appears inflationary, as consumer price, producer price, import price and export price all increase; and in the medium run, depreciation appears contractionary as personal consumption, consumer confidence, stock price and housing start tend to fall.Research limitations/implicationsSome caveats remain: first, our simple model symmetrically estimates depreciation shock and appreciation shock and, hence, cannot draw inferences for how exchange rate appreciation and depreciation may affect the US economy asymmetrically. Second, the simple model used did not distinguish the different possible sources of exchange rate depreciation shock, the knowledge of which may lead to richer policy implications and is the direction of research for the future.Originality/valueThis research contributes to the literature of whether exchange rate is expansionary or contractionary to the US economy using the FAVAR model. This is the first comprehensive study in the literature studying the pervasive effects of the exchange rate on the broad spectrum of the US economy in one integrated model.

Transmission of monetary policy and exchange rate shocks under foreign currency lending

This paper analyses the differences in reaction of domestic and foreign currency lending to monetary and exchange rate shocks, using a panel VAR model estimated for the three biggest Central and Eastern European countries (Poland, the Czech Republic and Hungary). Our results point toward a drop in domestic currency loans and an increase of foreign currency credit in reaction to monetary policy tightening in Poland and Hungary, suggesting that the presence of foreign currency debt weakens the transmission of monetary policy. A currency depreciation shock leads to an initial decline in foreign currency lending, but also in loans denominated in domestic currency as central banks react to a weaker exchange rate by increasing the interest rates. However, after several quarters, credit in foreign currency accelerates, indicating that borrowers start using it to substitute for depressed domestic currency lending.

Capital Controls and Misallocation in the Market for Risk: Bank Lending Channel

Foreign currency debt has led to many crises in emerging markets. However, in the past decade, firms in emerging economies have drastically increased their foreign currency borrowing, making them significantly exposed to depreciation shocks. To reduce their exposure to external shocks, central banks have increased their use of capital controls. In this paper I study whether capital controls can have the unintended consequence of inducing firms to borrow more in foreign currency. I exploit heterogeneity in the strictness of capital controls across Peruvian banks to provide novel causal evidence of the effect of capital controls on local firms' dollar borrowing from banks. Using a unique dataset that includes all foreign exchange transactions and loans given by Peruvian banks, I find that capital controls encourage firms to take more foreign currency loans. I describe a new mechanism to explain these findings, in which capital controls induce local banks to shift exchange rate exposure away from foreigners and onto domestic firms. This is worrisome as the literature shows that depreciation shocks have led to significant reductions in investment and employment for these firms.

Does real exchange rate depreciation increase productivity? Analysis using Korean firm‐level data

AbstractWe examine the effects of real exchange rate (RER) depreciation shocks on firm productivity. Using the firm‐level data of Korean manufacturing industries for 2006–13, we distinguish between yearly RER movement and persistent RER depreciation during 2007–09 and analyse how each affects productivity. We find the positive effect of RER depreciation on productivity among exporters, and this positive effect increases with higher export exposure. However, the positive productivity gain disappears when the depreciation persists. Our findings suggest that while immediate depreciation leads to productivity upgrade via price competitiveness and scale expansion, persistent depreciation nullifies the productivity gain by slackening the innovation effort.

Do exchange rate and oil price shocks have asymmetric effect on inflation?: some evidence from Nigeria

The effects of exchange rate and oil price on inflation have been fundamental issues in the macroeconomic literature. As a result, a number of studies have been devoted to examining the effects of exchange rate and oil price on inflation using various econometric approaches to measure the effects. However, most of the empirical studies employed restrictive models. This study, therefore, investigates the asymmetric effects of exchange rate and oil price shocks on inflation in Nigeria using monthly data obtained from the Central Bank of Nigeria (CBN) Statistical Bulletin for the period 2006M1-2016M6. The study employs the impulse response functions (IRFs) to determine the reaction of inflation to shocks from exchange rate and oil price. The IRFs are estimated from the vector autoregressive error correction (VECM) model. The results suggest that the immediate effect of a shock to the exchange rate in 12 months is about 50% increase in the price level. While the effect of an exchange rate depreciation shock is about 41% increase in the price level, the effect of an exchange rate appreciation is about 14% decrease in the price level. Similarly, the immediate effect of a shock to the oil price in 12 months is about 52% increase in the price level. While the effect of an increase in oil price in 12 months is about 43% increase in the price level, the effect of a decrease in oil price is surprisingly about 29% increase in the price level. Moreover, there is an evidence of significant effects of exchange rate and oil price shocks on inflation in the long run. The policy implication of this study, for an oil exporter such as Nigeria, is that monetary policymakers will have to keep the inflation rate at the comfort zone and stabilize the Nigerian currency. From a structural policy perspective, the falling crude oil price has certainly strained Nigeria. The country should, therefore, reshape its policy to redouble efforts to diversify its trade activities from oil.

Does Real Exchange Rate Depreciation Increase Productivity?: Analysis Using Korean Firm-Level Data

We examine the effects of real exchange rate (RER) depreciation shocks on firm productivity. Using the firm-level data of Korean manufacturing industries for 2006–2013, we distinguish between yearly RER movement and persistent RER depreciation during 2007–2009 and analyze how each affects productivity. We find the positive effect of RER depreciation on productivity among exporters and this positive effect increases with higher export exposure. However, the positive productivity gain disappears when the depreciation persists. Our findings suggest that while immediate depreciation leads to productivity upgrade via price competitiveness and scale expansion, persistent depreciation nullifies the productivity gain by slackening the innovation effort.

Outside the Band: Depreciation and Inflation Dynamics in Chile

This paper examines inflation dynamics in Chile during the last peso depreciation episode 2013-15. The evidence is for substantial pass-through effects to inflation, given the large and persistent depreciation movement. Widespread indexation practices in non-traded goods markets are found to amplify the inflation response to the depreciation, while the role of wage indexation is less relevant to the inflation dynamics. Overall, inflation would have remained within the central bank’s target band absent the peso depreciation. The analysis also shows that tightening monetary policy in response to a depreciation shock can be costly in terms of output: the response of activity to rates is found to be strong, while the transmission from activity to inflation is found to be weak. Simulations under uncertainty about the extent of the pass-through also suggest that monetary policy can play a countercyclical role in the face of depreciation shocks at a moderate inflationary cost, as long as inflation expectations remain anchored.

Testing of currency substitution effect on exchange rate volatility in Serbia

Despite numerous different definitions existing in the literature, currency substitution is generally understood as a phenomenon when domestic residents prefer to use foreign currency rather than domestic currency. The main reasons for such phenomenon include high and volatile inflation, strong depreciation of national currency and high interest rate differential in favour of foreign currency. Currency substitution, as a monetary phenomenon, is widely spread in Latin American, Eastern European and some Asian countries. This paper is dedicated to the influence of currency substitution on exchange rate volatility in Serbia. The research included testing of three hypotheses: (i) currency substitution positively affects depreciation rate volatility, (ii) depreciation rate volatility has stronger responses to the past negative than to the past positive depreciation shocks, and (iii) currency substitution positively affects expected depreciation rate. The analysis was implemented for the period 2002:m1-2015:m12 (2004:m1-2015:m12), applying modified EGARCH-M model. Based on the obtained results, all three hypotheses have been supremely rejected regardless of the manner of quantification of currency substitution.

Generational Risk -- Is it a Big Deal? Simulating an 80-Period OLG Model with Aggregate Shocks

The theoretical literature presumes generational risk is large enough to merit study and that such risk can be meaningfully shared via appropriate government policies. This paper assesses these propositions. It develops a computational technique to overcome the curse of dimensionality and measure generational risk in an 80-period OLG model. The model features isoelastic preferences, moderate risk aversion, Cobb-Douglas technology, and shocks to both TFP and capital depreciation. When shocks are calibrated using empirically plausible parameter values (our baseline model), the model reproduces the U.S. variability of output and wages. But it overstates the variability of the economy’s overall return to aggregate wealth. Even so, the model understates the economy’s risk premium (the mean return on aggregate wealth less the mean return on safe assets). But, as shown by Constantinides, Donaldson, and Mehra (2002) and Hasanhodzic (2014), adding hard or increasing borrowing costs can readily reduce equilibrium risk-free rates to essentially any desired level with little or no impact on the economy’s key macro variables. Based on this calibration, we nd that generational risk is small and that Social Security can exacerbate it. When depreciation shocks are accentuated to reproduce the observed variability of equity returns, as in Krueger and Kubler (2006), the model’s risk premium is close to the equity premium observed in the stock market. Yet, with this calibration, the model greatly overstates the variability of output and wages. It also produces substantial generational risk|risk that Social Security can materially reduce. Under both calibrations, we nd that even a one-period bond market is very eective, indeed far more eective than Social Security, in sharing risks among contemporaneous generations. We also nd that policy-induced intergenerational redistribution can produce far larger generational risk than macroeconomic uctuations.

Policy transmissions, external imbalances, and their impacts: Cross-country evidence from BRICS

This paper provides an empirical exploration of the interaction between fiscal policy, monetary policy, exchange rates, and external balances as well as their impacts on real economic growth and inflation for the BRICS countries. A panel VAR model is employed to assess the dynamic relationships. Our results generally confirm the significant impacts of a monetary shock on real economic activity but the effect of fiscal policy appears to be much weaker from the cross-country perspective. We do not find evidence supporting the “twin deficits” hypothesis but the positive interaction between inflation and interest rates – the “price puzzle” – is documented. When bilateral exchange rates and trade deficits (vis-à-vis the US) are used, we find that the BRICS–US bilateral trade balances do not react considerably to currency depreciation shocks, indicating that exchange rates may not play a critical role in the adjustment of large trade deficits for the U.S.

Analyzing the Exchange Rate Pass-through in Mexico: Evidence Post Inflation Targeting Implementation

This paper presents an analysis of the exchange rate pass-through mechanism for the Mexican economy after the formal adoption of inflation targeting policy. In particular, this research work analyzes how a change in the nominal exchange rate depreciation is transmitted to domestic prices along the distribution chain of pricing. The analysis is carried out using a recursive Structural Vector Autorregression with exogenous variables (recursive SVAR-X) model, which aims at the estimation of structural impulse-response-functions as a tool to analyze the degree and speed of the effect of exchange rate depreciation changes on domestic prices. Additionally, variance decompositions are computed to capture the relative importance of exchange rate depreciation shocks in explaining inflation fluctuations. Our results show that, for the period of analysis (after the formal adoption of inflation targeting in Mexico), the exchange rate pass-through to consumer prices is quite small and fast and exchange rate surprises are not relevant to explain consumer price inflation variation.

Wars as Large Depreciation Shocks

In this paper, we propose a theoretical framework to investigate the impact of conflicts and wars on key macroeconomic aggregates and welfare. Using a panel data with 9 countries from 1870 onwards, we first show that the consumption-to-output ratio is minimal during WWII for participants. While this can be explained by an increase in public spending in the USA, this can not be the case in other countries that participated in WWII, as they experience a large fall in output during wartime. To account for this, we build a variation of a Real Business Cycle model first proposed by Hercowitz and Sampson (1991). We extend the initial model to account for specific shocks that destroy private and public capital stocks -- as conflicts do -- by assuming an (exogenously) time-varying depreciation rate of the stock of capital. In addition, the model imbeds generalized TFP shocks capturing standard technological factors as well as the potential effects of war on the labor force. The model is estimated and used (i) to assess the importance of depreciation shocks during war episodes, and (ii) to quantify the welfare effects of conflicts. We show that depreciation shocks are crucial to account for the macroeconomic dynamics of countries that have experienced large war-related destruction, and that the welfare losses from fluctuations can be quite large when considering data samples that include major war episodes.

NEW PERSPECTIVES ON DEPRECIATION SHOCKS AS A SOURCE OF BUSINESS CYCLE FLUCTUATIONS

In this paper we study the transmission of capital depreciation shocks. The existing literature in the real business cycle tradition has concluded that these shocks are irrelevant to business cycle fluctuations. We show that they are potentially important drivers of aggregate fluctuations in a new Keynesian model. Nominal rigidities and some persistence in the shock process are the key ingredients that generate co-movement across real variables.