## 5. Macroeconomic Response to a Decline in the Demand for Colombian Exports under a Prolonged Financing Shock

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### I. Introduction — context and objectives
- External shocks have historically contributed to a large share of the variance of output in Colombia.
- Recent outlook (as presented in the source):
  - Growth projected to slow from over 7 percent in 2007 to about 3 percent in 2008.
  - Growth for 2009 projected to ease further.
  - Inflation projected to decline but remain above the BdR medium-term target of 2-4 percent.
- Paper objective:
  - Use an open-economy structural model (Colombia-specific GIMF) to assess impacts of external shocks (export demand shock, world growth decline, increase in global risk aversion) and alternative monetary and fiscal policy responses.
  - Emphasis on assessing fiscal policy effectiveness under differing financing conditions (normal vs. adverse), given potential non-linearities in risk premia.

### II. Model framework (GIMF, Colombia-specific)
- Key non-Ricardian features that generate fiscal policy effects:
  - Overlapping generations (OLG) with finite lifetimes and myopic perceptions of future tax liabilities.
  - Life-cycle labor productivity with declining productivity as workers age.
  - Liquidity-constrained consumers (LIQ) who change consumption one-for-one with after-tax income.
  - Distortionary payroll and capital income taxes.
- Nominal and real rigidities that make monetary policy effective:
  - Phillips curve for each sector, wage rigidities, pricing to market.
  - Consumption habits; adjustment costs for investment, imports, and retail sales.
- Policy rules:
  - Monetary policy: inflation forecast-based (IFB) rule for nominal interest rate (consistent with BdR’s MMT IFB specification).
  - Fiscal policy: simple fiscal balance-to-GDP reaction with response parameter d:
    - d = 0: fiscal balance kept constant (procyclical, “balanced budget” rule).
    - d = 1: structural balance rule where automatic stabilizers operate (cyclically neutral).
- Financing and risk premia:
  - Domestic interest rates incorporate country-specific risk premium ρt via a risk-adjusted UIP:
    - (1 + it) = (1 + iRW,t) E(1 + εt+1) + ρt
  - Non-linear specification for ρt:
    - ρt = max{0, δ1 + δ2*(debt/GDP) + δ3*(debt/GDP)^3}
  - Shifts in parameter δ1 used to simulate changes in global risk aversion and financing conditions.

### III. Scenarios simulated and main quantitative assumptions
- Horizon: model results reported over 32 quarters (deviations from baseline).
- Scenario definitions:
  - Case 1 (trade shock): exogenous decline in Colombian exports calibrated so net exports initially reduced about 10 percent (2 percent of GDP); shock follows AR(1) with half-life of five years.
  - Case 2 (world growth shock): decline in world growth of two percentage points; temporary preference-for-savings shock in rest of world.
  - Case 3 (risk premium shock): exogenous 100 basis point increase in risk premium (δ1), following AR(1) with half-life of 1½ years.
- Policy responses evaluated for each shock:
  - Baseline: rapid monetary policy response (IFB) and fiscal policy with constant deficit rule (d = 0).
  - Delayed monetary response: monetary policy unchanged for a short period (inertia mechanically increased: persistence of nominal rates to .99 for first two quarters, .75 for third/fourth, 0.5 thereafter), fiscal policy as baseline.
  - Neutral fiscal stance: cyclically neutral fiscal policy (d = 1) allowing budget deficit to rise with automatic stabilizers; monetary reaction same as baseline.
- Financing-condition variations:
  - Normal financing conditions: calibrated as in Leigh (2008), temporary deficits have minor impact on interest rates.
  - Adverse financing conditions: simulate additional risk premium shocks, including:
    - Sharp 350 basis point short-lived shock (half-life ½ year).
    - Prolonged small 15 basis point shock (half-life 5 years) capturing credibility problems.

### IV. Case results — qualitative and key quantitative findings

- Case 1: Exogenous reduction in trade (exports)
  - First-year responses under baseline policy:
    - Real exchange rate depreciates by about 4 percent in the first year.
    - Output deteriorates about 1¾–3 percent in the first year, depending on policy response.
    - Current account deficit deteriorates by about one percentage point of GDP.
  - Role of monetary policy:
    - Baseline monetary easing reduces real interest rates by about 65 basis points in the first year.
    - Weaker/sluggish monetary response -> sharper initial decline in output and consumption, greater medium-term volatility, and need for stronger later policy adjustment.
  - Role of fiscal policy under normal financing:
    - Neutral fiscal stance implies deterioration in fiscal deficit of almost ¾ percent of GDP.
    - Neutral stance reduces decline in output by about ½ percentage point and household consumption by about 1 percentage point in the first year.
  - Reserves and external debt context:
    - Colombia assumed to have reserves about 10 percent of GDP and external debt about 20 percent of GDP, so a one percentage point CA deficit increase could be accommodated under normal financing.

- Case 2: Decline in world growth (two percentage points)
  - Colombia experiences a decline in growth of about ½ percentage point in the first year.
  - Exchange rate appreciation and monetary easing allow higher consumption and imports, raising the current account deficit.
  - Neutral fiscal policy helps ease the effect on growth.
  - Under inflation-targeting framework, decline in Colombian output is between a quarter and a third of that in the rest of world.

- Case 3: Increase in risk premium (100 basis points)
  - Immediate effects:
    - Currency depreciation arises, generating inflationary pressure which prompts monetary tightening.
    - Higher external borrowing costs depress consumption and investment; depreciation raises exports and lowers imports; external current account improves initially.
  - Dynamics and persistence:
    - Increase in risk premia has long-lasting effect on output; output returns to baseline only after a very long period.
    - Shock acts partly like a supply shock: depreciation raises inflation and reduces output.
  - Policy interactions:
    - Monetary policy tightening needed to return inflation to target; easing would exacerbate inflationary pressures.
    - Neutral fiscal stance is not effective at stabilizing output in this scenario because tighter monetary policy offsets fiscal stimulus; return of output similar under neutral fiscal stance and constant deficit rule.
  - Policy implication: under risk premia shocks, accommodative fiscal policy may be ineffective.

- Combined trade shock + adverse financing conditions
  - Simulation: add a sharp 350 basis point short-lived risk premium shock (half-life ½ year) to the trade shock.
  - Macro outcome differences vs. normal financing:
    - Combined shocks generate larger devaluation and substantial inflationary pressures, leaving little scope for monetary accommodation.
    - Under combined shocks, devaluation can be large enough to improve the current account rather than worsen it.
  - Fiscal effectiveness:
    - Under normal financing, neutral fiscal policy reduces the squared deviation of output from steady state by 44 percent (first five years) relative to constant deficit rule.
    - Under adverse financing (350bp shock), reduction is less than 1 percent — fiscal policy little help in stabilizing output.
  - Credibility problem scenario:
    - Simulate a small 15 basis point but long-lived (half-life 5 years) rise in risk premia triggered by a deficit increase.
    - Even this small, persistent increase can render fiscal policy largely ineffective.
    - Emphasizes importance of credible medium-term fiscal framework to anchor expectations.

### V. Policy implications — distilled recommendations and caveats
- Monetary policy and exchange rate flexibility:
  - Flexible exchange rate and agile monetary policy response can substantially limit adverse effects of external shocks on output, consumption, and external accounts.
  - Rapid monetary easing in response to demand shocks (trade or world growth) helps stabilize output and allows exchange rate depreciation to aid adjustment.
  - Increases in risk premia produce inflationary pressure through depreciation; monetary easing in that context is ill-advised.
- Fiscal policy conditionality on financing conditions:
  - Under normal financing conditions, adopting a cyclically neutral fiscal stance (allowing automatic stabilizers to operate; d = 1) can meaningfully reduce output costs of external shocks (example: 44 percent reduction in squared deviations for a trade shock).
  - Under adverse financing conditions (large or persistent increases in risk premia), the benefits of accommodative fiscal policy are greatly reduced or nullified (e.g., less than 1 percent reduction under a 350bp short-lived shock).
  - If increased deficits themselves trigger higher risk premia (credibility problems), even small persistent increases in risk premia can render fiscal stimulus ineffective.
- Operational guidance:
  - Policy choices on allowing automatic stabilizers to operate should be judged empirically and cautiously, taking into account:
    - Availability of financing,
    - Market expectations about fiscal credibility,
    - Size and persistence of any financing shock (risk premia).
  - Maintain credible medium-term fiscal framework to anchor expectations and preserve scope for countercyclical fiscal policy when financing conditions are favorable.

*Source: Chapter 5, “Macroeconomic Response to a Decline in the Demand for Colombian Exports under a Prolonged Financing Shock,” IMF working paper (GIMF-based simulations and policy analysis).*

### References..............................................................................................................

### References................................................................................................................................17

### Figures
- 1. Macroeconomic Effects of a Decline in Demand for Colombian Exports Under Different Policy Responses ...................................................................................................................8
- 2. Macroeconomic Response to a Decline in World Growth ..................................................10
- 3. Macroeconomic Effects of Temporary Increase in Risk Premia .........................................11
- 4. Macroeconomic Response to a Decline in the Demand for Colombian Exports under Adverse Financing Conditions ............................................................................................14

*Source: _wp0959 - References..............................................................................................................*

### 5. Macroeconomic Response to a Decline in the Demand for Colombian Exports under a

### 5. Macroeconomic Response to a Decline in the Demand for Colombian Exports under a Prolonged Financing Shock

### I. Introduction — context and objectives
- External shocks have historically contributed to a large share of the variance of output in Colombia.
- Recent outlook: growth projected to slow from over 7 percent in 2007 to about 3 percent in 2008; growth for 2009 projected to ease further; inflation projected to decline but remain above the BdR medium-term target of 2-4 percent.
- Paper objective: use an open-economy structural model (Colombia-specific GIMF) to assess impacts of external shocks (export demand shock, world growth decline, increase in global risk aversion) and alternative monetary and fiscal policy responses.
- Emphasis on assessing fiscal policy effectiveness under differing financing conditions (normal vs. adverse), given potential non-linearities in risk premia.

### II. Model framework (GIMF, Colombia-specific)
- Key non-Ricardian features that generate fiscal policy effects:
  - Overlapping generations (OLG) with finite lifetimes and myopic perceptions of future tax liabilities.
  - Life-cycle labor productivity with declining productivity as workers age.
  - Liquidity-constrained consumers (LIQ) who change consumption one-for-one with after-tax income.
  - Distortionary payroll and capital income taxes.
- Nominal and real rigidities that make monetary policy effective:
  - Phillips curve for each sector, wage rigidities, pricing to market.
  - Consumption habits; adjustment costs for investment, imports, and retail sales.
- Policy rules:
  - Monetary policy: inflation forecast-based (IFB) rule for nominal interest rate (consistent with BdR’s MMT IFB specification).
  - Fiscal policy: simple fiscal balance-to-GDP reaction:
    - Fiscal rule expressed with response parameter d.
    - d = 0: fiscal balance kept constant (procyclical, “balanced budget” rule).
    - d = 1: structural balance rule where automatic stabilizers operate (cyclically neutral).
- Financing and risk premia:
  - Domestic interest rates incorporate country-specific risk premium ρt via a risk-adjusted UIP:
    - (1 + it) = (1 + iRW,t) E(1 + εt+1) + ρt  (as presented in text; variables preserved in original form).
  - Non-linear specification for ρt: ρt = max{0, δ1 + δ2*(debt/GDP) + δ3*(debt/GDP)^3} (presented in the text in verbal form and equation numbering preserved).
  - Shifts in parameter δ1 used to simulate changes in global risk aversion and financing conditions.

### III. Scenarios simulated and main quantitative assumptions
- Horizon: model results reported over 32 quarters (deviations from baseline).
- Scenario definitions:
  - Case 1 (trade shock): exogenous decline in Colombian exports calibrated so net exports initially reduced about 10 percent (2 percent of GDP); shock follows AR(1) with half-life of five years.
  - Case 2 (world growth shock): decline in world growth of two percentage points; temporary preference-for-savings shock in rest of world.
  - Case 3 (risk premium shock): exogenous 100 basis point increase in risk premium (δ1), following AR(1) with half-life of 1½ years.
- Policy responses evaluated for each shock:
  - Baseline: rapid monetary policy response (IFB) and fiscal policy with constant deficit rule (d = 0).
  - Delayed monetary response: monetary policy unchanged for a short period (inertia mechanically increased: persistence of nominal rates to .99 for first two quarters, .75 for third/fourth, 0.5 thereafter), fiscal policy as baseline.
  - Neutral fiscal stance: cyclically neutral fiscal policy (d = 1) allowing budget deficit to rise with automatic stabilizers; monetary reaction same as baseline.
- Financing-condition variations:
  - Normal financing conditions: calibrated as in Leigh (2008), temporary deficits have minor impact on interest rates.
  - Adverse financing conditions: simulate additional risk premium shocks (examples below), including a sharp 350 basis point short-lived shock (half-life ½ year) and a prolonged small 15 basis point shock (half-life 5 years) capturing credibility problems.

### IV. Case results — qualitative and key quantitative findings

- Case 1: Exogenous reduction in trade (exports)
  - First-year responses under baseline policy:
    - Real exchange rate depreciates by about 4 percent in the first year.
    - Output deteriorates about 1¾–3 percent in the first year, depending on policy response.
    - Current account deficit deteriorates by about one percentage point of GDP.
  - Role of monetary policy:
    - Baseline monetary easing reduces real interest rates by about 65 basis points in the first year.
    - Weaker/sluggish monetary response -> sharper initial decline in output and consumption, greater medium-term volatility, and need for stronger later policy adjustment.
  - Role of fiscal policy under normal financing:
    - Neutral fiscal stance implies deterioration in fiscal deficit of almost ¾ percent of GDP.
    - Neutral stance reduces decline in output by about ½ percentage point and household consumption by about 1 percentage point in the first year.
  - Reserves and external debt context:
    - Colombia assumed to have reserves about 10 percent of GDP and external debt about 20 percent of GDP, so a one percentage point CA deficit increase could be accommodated under normal financing.

- Case 2: Decline in world growth (two percentage points)
  - Colombia experiences a decline in growth of about ½ percentage point in the first year.
  - Exchange rate appreciation and monetary easing allow higher consumption and imports, raising the current account deficit.
  - Neutral fiscal policy helps ease the effect on growth.
  - Under inflation-targeting framework, decline in Colombian output is between a quarter and a third of that in the rest of world (text compares to other empirical estimates).

- Case 3: Increase in risk premium (100 basis points)
  - Immediate effects:
    - Currency depreciation arises, generating inflationary pressure which prompts monetary tightening.
    - Higher external borrowing costs depress consumption and investment; depreciation raises exports and lowers imports; external current account improves initially.
  - Dynamics and persistence:
    - Increase in risk premia has long-lasting effect on output; output returns to baseline only after a very long period.
    - Shock acts partly like a supply shock: depreciation raises inflation and reduces output.
  - Policy interactions:
    - Monetary policy tightening needed to return inflation to target; easing would exacerbate inflationary pressures.
    - Neutral fiscal stance is not effective at stabilizing output in this scenario because tighter monetary policy offsets fiscal stimulus; return of output similar under neutral fiscal stance and constant deficit rule.
  - Policy implication: under risk premia shocks, accommodative fiscal policy may be ineffective.

- Combined trade shock + adverse financing conditions (Section IV)
  - Simulation: add a sharp 350 basis point short-lived risk premium shock (half-life ½ year) to the trade shock.
  - Macro outcome differences vs. normal financing:
    - Combined shocks generate larger devaluation and substantial inflationary pressures, leaving little scope for monetary accommodation.
    - Under combined shocks, devaluation can be large enough to improve the current account rather than worsen it.
  - Fiscal effectiveness:
    - Under normal financing, neutral fiscal policy reduces the squared deviation of output from steady state by 44 percent (first five years) relative to constant deficit rule.
    - Under adverse financing (350bp shock), reduction is less than 1 percent — fiscal policy little help in stabilizing output.
  - Credibility problem scenario:
    - Simulate a small 15 basis point but long-lived (half-life 5 years) rise in risk premia triggered by a deficit increase.
    - Even this small, persistent increase can render fiscal policy largely ineffective.
    - Emphasizes importance of credible medium-term fiscal framework to anchor expectations.

### V. Policy implications — distilled recommendations and caveats
- Monetary policy and exchange rate flexibility:
  - Flexible exchange rate and agile monetary policy response can substantially limit adverse effects of external shocks on output, consumption, and external accounts.
  - Rapid monetary easing in response to demand shocks (trade or world growth) helps stabilize output and allows exchange rate depreciation to aid adjustment.
  - Increases in risk premia produce inflationary pressure through depreciation; monetary easing in that context is ill-advised.
- Fiscal policy conditionality on financing conditions:
  - Under normal financing conditions, adopting a cyclically neutral fiscal stance (allowing automatic stabilizers to operate; d = 1) can meaningfully reduce output costs of external shocks (example: 44 percent reduction in squared deviations for a trade shock).
  - Under adverse financing conditions (large or persistent increases in risk premia), the benefits of accommodative fiscal policy are greatly reduced or nullified (e.g., less than 1 percent reduction under a 350bp short-lived shock).
  - If increased deficits themselves trigger higher risk premia (credibility problems), even small persistent increases in risk premia can render fiscal stimulus ineffective.
- Operational guidance:
  - Policy choices on allowing automatic stabilizers to operate should be judged empirically and cautiously, taking into account:
    - Availability of financing,
    - Market expectations about fiscal credibility,
    - Size and persistence of any financing shock (risk premia).
  - Maintain credible medium-term fiscal framework to anchor expectations and preserve scope for countercyclical fiscal policy when financing conditions are favorable.

*Source: Chapter 5, “Macroeconomic Response to a Decline in the Demand for Colombian Exports under a Prolonged Financing Shock,” IMF working paper (GIMF-based simulations and policy analysis).*

### References

### _wp0959 - References

### Referenced works

- Abrego, Lisandro, and Pär Österholm, 2008, “External Linkages and Economic Growth in Colombia: Insights from a Bayesian VAR Model,” IMF Working Paper WP 08/46 (Washington: International Monetary Fund).
- Banco de la República, 2008, Informe de Inflación (March).
- Gómez, Javier, José Darío Uribe, and Hernando Vargas, 2002, “The Implementation of Inflation Targeting in Colombia,” Borradores Semanales de Economía, No. 202.
- Kumhof, Michael, and Douglas Laxton, 2007, “A Party Without a Hangover? On the Effects of U.S. Government Deficits,” IMF Working Paper No. 07/202 (Washington: International Monetary Fund).
- Leigh, Daniel, 2008, “Achieving a Soft Landing: The Role of Fiscal Policy,” IMF Working Paper WP/08/69 (Washington: International Monetary Fund).
- López, Martha, 2003, “Efficient Policy Rules for Inflation Targeting in Colombia,” Borradores Semanales de Economía, No. 240.

*Source: _wp0959 - References*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp0959.pdf_