Note of the guest editors

Special edition on global business cycle, the financial crisis and its effects on emerging economies

This special issue of the journal Ensayos sobre Política Económica focuses on global business cycles, the financial crisis and its effects on emerging economies. When the subject for this special number was chosen the global economy was in the midst of an international crisis and there were many questions about the effects this situation would have on emerging economies. Our call was enthusiastically received by many and we selected those works that, in our estimation, best answer such questions. Also, the contributions made by the international guests to the seminar where the chosen papers were introduced were extremely helpful. These guests were: Andrew Levin, Director of the Division of Monetary Affairs of the Board of Governors of the United States Federal Reserve, Jean Charles Rochet, from the University of Toulouse I, and Varadarajan Chari from the University of Minnesota.

The unfolding of the global financial and economic crisis which began in 2007 has made evident the vulnerability of real economic activity to strong fluctuations in asset prices. Given this situation, and for an economy such as the one in our country, it is essential to understand certain issues: which is the optimal monetary policy in an economy like the Colombian, exposed to swings in asset prices? , and what are the implications, in terms of central bank losses, when a standard simple rule is followed instead of the optimal monetary policy?

The aim of the paper written by Martha López and Juan David Prada was, precisely, to give answer to these questions¹. With this purpose, they use a Dynamic Stochastic General Equilibrium (DSGE) model with physical capital and sticky wages for the Colombian economy. The result was the optimal monetary policy. Then, they analyze the dynamic effects of news about a future technology improvement under the optimal policy rule and, alternatively, under specifications of simple rules and definitions of the output gap.

Along the same line, David Mayes and Matti Virén explore the contribution that asset prices make to fluctuations in the economy and to inflation, and hence to monetary policy. For this, they use a large international panel for the 1970–2008 period to find that house prices are important in the determination of economic activity and monetary policy, but that stock market prices, while offering information in many periods, have a weaker and less well determined linkage.They also discover that the effects are asymmetric over the course of the economic cycle. Using an augmented Taylor rule, they show that monetary policy has not reacted much to asset prices but that long-run interest rates are clearly affected by house price inflation. Relationships tend to be weaker in recent years, probably as a result of greater stability in output growth and inflation. Based on the results obtained, the authors suggest that it would be important for central banks to consider asset prices in deciding monetary policy.

Another group of articles explores the perspective of the financial sector in mainstream economic theory.

This is, for many, one of the key aspects of the international crisis since models and tools available when this situation set off were not suitable to fully understand its causes and implications.

With the purpose of comprehending the role of the banks in modern economies, George McCandless explores their social value. The author compares the utility of individuals in an economy with and without banks. To make the comparison interesting, the economy without banks has cash-in-advance money. Families use this money for consumption and for precautionary (emergency) purposes and firms use it to pay their wage bill. In the economy with banks, precautionary funds are deposited in banks, which lend this money to firms. In economies with banks output is generally higher, people have a higher utility and live longer. The price level is usually higher too.

In turn, Alejandro Torres, Remberto Rhenals and Wilman Gómez explore the possible effects of the Lender of Last Resort Policy of central banks on the process of overcoming financial crises and its implications in terms of growth. To this end, they use a customized Dynamic General Equilibrium Model which explicitly includes the financial system and the Liquidity Support policy of the central bank. The simulations have shown that this type of policy facilitates overcoming financial crises in less time, but that it also delays the economy’s readjustment in the long term and increases its volatility.

Emerging economies can have a distinct behavior during crises. It has been documented that when an international crisis occurs, transmission channels to such economies are the reduction of international trade flows as demand contracts, of capital flows as a result of a decrease in confidence, and the reduction of remittances from migrant workers as labor markets collapse in host countries. The next group of articles explores these fundamental issues in more depth.

Andrés Fernández questions the ability of frictionless small open economy models driven solely by technology shocks to account for business cycles in developing countries. The author does not find evidence of it. To prove this, he builds a DSGE model that jointly includes a variety of real perturbations in addition to technology shocks, such as procyclical fiscal policies, terms of trade fluctuations, and perturbations to the foreign interest rate coupled with financial frictions. To estimate the model’s parameters the author uses Bayesian methods on high and low frequency data from a developing —and “tropical”— country, Colombia.

He finds that interest rate shocks are crucial and that financial frictions play a central role as propagating mechanisms of transitory technology shocks. These two driving forces alone can account well for the observed properties of the Colombian business cycle. Other structural shocks, such as terms of trade fluctuations and level shifts in the technology process, do not appear to be relevant in the past decade and a half, but their importance increases when a longer span of data is considered.

Marcelo Sánchez investigates the role of domestic and external factors in explaining business cycle and international trade developments in fifteen emerging market economies. Results obtained using a sign-restricted VAR show that developments in real output, inflation and international trade variables are dominated by domestic shocks. External shocks, on average, explain a fraction of no more than 10% of the variation in the endogenous variables considered in this study. Concerning impulse responses, consumer prices and real imports are overall the endogenous variables most affected by domestic disturbances. Consumer prices are mostly driven by technology and risk premium shocks. The shocks inducing the largest effects tend to be monetary disturbances, which can be traced to unpredictable monetary policy. These shocks generate relatively large impacts on real imports, which -owing to muted reactions in real exports-, carry over to the trade balance, alongside more modest changes in consumer prices and real output.

In closing, Veronica Bayangos and Karel Jansen explore the cyclical dynamics of remittances and analyze the macroeconomic impact of remittances and the monetary policy implications. In this endeavor they use the case of the Philippines —one of the countries where remittances are highly important for the economic system— as an example. Through a dynamic structural quarterly macroeconometric model of the Philippines the authors trace the various channels through which remittances affect the main macroeconomic variables. When assessing the impact of the 2008 global financial crisis, remittances should also be considered as a transmission channel. The authors find that remittances are driven by the economic cycle of the main host countries and that the ongoing recession will thus lead to a decline in transfers. Using the aforementioned model they identify the impact of changes in remittances on important economic variables such as aggregate demand, money supply and interest rates, the exchange rate, and labor supply and wages. Additionally, the authors establish that fluctuations in remittance flows have had a significant effect over the years, and consequently, economic policy makers must take them into account. The model simulations show that the impact of the US recession on the Philippine economy is more severe once the endogeneity and procyclicality of remittances are taken into account.

Andrés González Gómez
Enrique López Enciso
Guest Editors Special Edition

COMMENTS

¹Refer to López, M. and Prada, J. D. “Optimal Monetary Policy and Asset Prices: the Case of Colombia” in this issue.