The balance sheet effect of firms and banks : a new open economy macroeconomics approach


Student thesis: Doctoral Thesis

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  • Ka Chung LAW

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Awarding Institution
Award date15 Jul 2003


In the "New Open Economy Macroeconomics" (NOEM) literature that studies the balance sheet effect of adverse external shocks in emerging market economies, floating exchange rate is the standard conclusion. By incorporating the balance sheet effect of both firms and banks into the NOEM framework, we show that the traditional conclusion is "not always standard" - the optimal exchange rate regime depends on which shock happens and how welfare is measured. The "standard conclusion" of fixed regime as always destabilising still holds if welfare is measured as cost of business cycles (second moment of utility). If welfare is measured as loss of or expected lifetime utility (zero and first moments respectively), then under world interest rate shock intermediate and floating regimes are optimal with fragile firm and fragile bank respectively, fixed is optimal under exports shock, and floating is optimal under monetary policy shock. To stabilise GDP, domestic price level is a better target than consumer price index. Moreover, the closed-form solution of the model shows that reducing the agency cost of banks rather than firms can lessen the real depreciation under adverse shocks. Most (75%) of the business cycle facts identified from the literature are matched by the simulated moments; and finally we compute the empirical moments of the bank balance sheet variables from four Asian economies, most of them (>70%) are matched by the simulated moments. Keywords: balance sheet effect, credit channel, emerging market, financial accelerator, exchange rate, monetary policy. JEL Classification: E32, E42, E52, F41.

    Research areas

  • Financial statements, Macroeconomics, Foreign exchange rates