## _wp11298 - 2.1 A Brief History ## Source details **Canonical URL:** [_wp11298 - 2.1 A Brief History](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2011/_wp11298.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2011/_wp11298.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2011/_wp11298.pdf.json) --- ### Overview - Emerging market economies integrated into global capital markets experience boom-bust cycles in international capital flows: strong inflows in good times and reversals that often trigger systemic financial crises. - Prudential controls on capital flows to emerging economies may be welfare-improving because they reduce the incidence and severity of financial crises and the pecuniary externalities that arise during such crises (Korinek, 2010a). ### Financial amplification: mechanism and consequences - Financial amplification characterized by a feedback loop: - (1) declining exchange rates and asset prices, - (2) adverse balance sheet effects (declining value of collateral and net worth), - (3) falling aggregate demand. - In presence of financial market imperfections and balance sheet constraints, shocks that reduce aggregate demand can lead to large, amplified effects on macroeconomic aggregates. - The paper uses “financial crisis” synonymously with financial amplification. ### Pecuniary externalities and distorted private incentives - Small market participants take exchange rates and asset prices as given, but their aggregate actions determine those prices; private agents neglect these price effects—pecuniary externalities. - Pecuniary externalities induce distortions in financing choices of emerging-market agents: - Too much debt, - Excessively risky forms of finance (e.g., foreign currency debt rather than FDI), - Excessively short maturities of debt. - Financial fragility is framed as an uninternalized by-product of external financing; Pigouvian-style interventions can align private and social costs. ### Historical evolution of crisis models and implications for capital controls - First-generation models: crises blamed on profligate government policies (Krugman (1979); Flood and Garber (1984)). - Second-generation models: devaluations as multiple-equilibrium phenomena (Obstfeld (1994)). - Early third-generation models: bailout guarantees encourage excessive risk-taking (McKinnon and Pill (1998); Krugman (2001)). - East Asian crisis (1997/98): short-term foreign currency-denominated debt amplified small shocks into self-reinforcing cycles of depreciation, asset-price decline, and contracting activity. - Formal models of financial amplification emerged (Krugman, 1999; Aghion et al., 2000) highlighting balance sheet effects as central. - Balance sheet effects and financial amplification imply pecuniary externalities, making free capital flows potentially inefficient. ### Scope and normative focus - Focus on prudential capital controls designed to correct economy-wide incentives for excessive risk-taking; “prudential” refers to measures imposed to stem buildup of risk before a financial crisis materializes. - Excludes capital controls on outflows or non-prudential motives; emphasizes residency-discriminating regulations over other macroprudential tools. - Survey largely limited to theoretical literature on prudential capital controls; empirical literature and endogeneity issues noted but not covered in depth. --- ### 2.2 Balance Sheet Effects and Financial Amplification ### Mechanism and feedback loop (three elements) 1. Declining Prices - Adverse shocks to aggregate demand lead to exchange rate depreciations and declining asset prices. - Exchange rate depreciations arise across model classes: real models without money; monetary models with passive or active policy; fiscal models where lower tax revenue increases seigniorage needs. - Asset price declines originate from changes in intertemporal marginal rate of substitution or reduced investment demand (q-theory). 2. Balance Sheet Effects - Depreciations and asset price declines reduce collateral and net worth, tightening access to credit. - Foreign-currency borrowing magnifies valuation effects as depreciation raises domestic value of debt. 3. Falling Aggregate Demand - Tighter credit reduces consumption and investment, lowering aggregate demand and further depressing prices. - Any of the three elements can be the initial trigger (capital outflows, valuation losses, export declines). - Capital flows become pro-cyclical: credit relaxes in good times and tightens in bad times, making flows destabilizing. - Price movements must be larger than absent balance sheet effects (overshooting): "For every three steps forward that the price movement makes in restoring market equilibrium, the economy slips two steps backward because of adverse balance sheet effects." ### Connections with closed-economy amplification literature - Falling asset prices central to closed-economy financial amplification (Fisher, 1933; Bernanke and Gertler, 1989; Kiyotaki and Moore, 1997). - Open-economy models add explicit exchange rate role; empirical evidence suggests exchange rate depreciations are crucial for balance sheet effects in small open economies (Frankel, 2005). ### Stylized Korinek-based model setup - Small open endowment economy, two periods t = 1 and 2. - Period 1 goods: tradable and non-tradable; relative price of non-tradable denoted p (real exchange rate). Period 2: only tradable goods. - Representative agent utility: U = log(c1) + cT,2, with c1 = (cT,1)^σ (cN,1)^{1−σ}. - Endowments: period 1 (yT,1,yN,1) normalized to (σ,1−σ); period 2 yT,2. - World gross interest rate set to 1; consumer inherits tradable debt d0; define m = yT,1 − d0. - Period 1 decision: borrow d1 to carry into period 2. - Budget constraints: - cT,1 + p cN,1 = m + p yN,1 + d1 - cT,2 + d1 = yT,2 ### Financial constraint (balance sheet microfoundation) - Borrowing constrained by d1 ≤ κ(yT,1 + p yN,1) with κ < σ/(1−σ). - Lenders can seize fraction κ of consumer income and convert non-tradables at market price p; a decline in p reduces collateral and borrowing capacity, capturing balance sheet effects. - Constraint variants: current-price dependent vs future-price dependent formulations across literature. - Key requirement for amplification: a relative price moves in a direction that hurts constrained agents when an adverse shock occurs, tightening constraints or reducing income/wealth. ### Model solution highlights and amplification - From FOCs and market clearing: - p = cT,1 / σ (real exchange rate increasing in tradable consumption cT,1). - Loose constraints (d0 ≤ κ): first-best allocation with cT,1 = σ, d1 = d0, p = 1; marginal value of liquidity Vfb_m = 1. - Binding constraints (d0 > κ): d1 = κ[yT,1 + p yN,1], cT,1 = m + d1; marginal value of liquidity Vcon_m = σ / cT,1 > Vfb_m. - Equilibrium expressions: - d1 = κ·(σ yT,1 + m yN,1) / (σ − κ yN,1) - cT,1 = σ·(m + κ yT,1) / (σ − κ yN,1) - Financial amplification: dcT,1/dm = σ / (σ − κ yN,1) > 1 — increases in m are amplified through appreciation, relaxed borrowing constraints, and further consumption increases. ### Pecuniary externalities and policy plan - Exchange rate depreciations and asset price declines during amplification generate pecuniary externalities. - Paper outlines plan to define externalities, assess when they justify policy intervention, formalize within model, and discuss implications for capital inflows and prudential controls. --- ### 3.1–3.3 Pecuniary Externalities, Efficiency, and Undervaluation of Liquidity ### Definitions and key distinctions - Externalities: indirect effects on others from an economic activity. - Two types: - Technological externalities: direct effects on utility/production (e.g., pollution). - Pecuniary externalities: effects operating via relative prices (e.g., price changes that redistribute welfare). - With complete markets and price-taking, pecuniary externalities need not imply Pareto inefficiency (first welfare theorem) provided local non-satiation holds. - When markets are incomplete or behavior noncompetitive, pecuniary externalities can cause inefficiencies (Greenwald and Stiglitz, 1986; Stiglitz, 1982). ### Borrowing-constrained example and coordination problem - Binding borrowing constraint prevents borrower and lender from equating marginal utilities; appreciation or higher asset prices that relax collateral constraints yield Pareto improvements. - Externalities constitute a coordination problem: decentralized agents fail to internalize price impacts; coordinated action would limit damaging relative price movements. ### Open-economy specifics - With complete markets, depreciation can be stabilizing (Friedman, 1953). With incomplete markets or borrowing constraints, depreciation can have net negative welfare effects for constrained domestic agents because negative income effects dominate. - If exchange rates or asset prices enter borrowing constraints directly, price movements can tighten constraints and reduce aggregate welfare — central to balance sheet effects and financial amplification. - Decentralized agents take prices as given and therefore undervalue aggregate impacts; a planner would internalize amplification effects. ### Constrained planner and Lemma 1 (Undervaluation of Liquidity) - Constrained social planner optimizes domestic consumers’ welfare subject to same borrowing/budget constraints; internalizes that exchange rate p is determined by marginal rate of substitution. - When constraint binds, decentralized agents undervalue liquidity relative to planner: - Decentralized marginal value Vcon^m = σ / cT,1 (from model). - Planner’s marginal value Vsp^m = σ / (m + κ yT,1 − κ yN,1) · (σ − κ yN,1)^{-1} (as given). - Comparison yields Vsp^m > Vcon^m when constraint binds. - Interpretation: holding liquidity m when constraints bind is a public good; planner ensures socially optimal provision. --- ### 4 Financing Decisions, Distortions, and Capital Controls ### Central role of marginal valuation of liquidity - Marginal valuation of liquidity (pricing kernel/stochastic discount factor) determines intertemporal allocations. - When constraints bind, planner and decentralized valuations differ; additional decision margins reveal distortions from undervaluation. ### Distortions from undervaluation - Undervaluation of liquidity creates financing distortions: - Overborrowing, - Excessive risk-taking, - Excessive short-term debt. - Literature groups distortions by: - Exchange rate externalities, - Asset price externalities, - Interest rate externalities. --- ### 4.1 Over-borrowing ### Mechanism and main finding - Lemma 1 implies decentralized agents over-borrow: they do not internalize full social cost of repayments when constraints bind, leading to excessive promised repayments relative to the constrained planner. - Excessive debt magnifies financial amplification, producing excessive volatility and less smooth consumption. - Policy implication: prudential capital controls on debt inflows are desirable to reduce private external borrowing. ### Three-period analytic illustration - Augmented model adds period 0: consumers with utility U = σ log(c^T_{0}) + log(c_1) + c^T_2, borrowing c^T_0 = d_0; m = y^T − d_0; FOC: σ / d_0 = V_m(·). - Result 1 (Over-borrowing): - If κ < σ, constrained social planner would take on less debt than decentralized agents. - If κ ≥ σ, no constraint and allocations coincide (d_0 = σ). - If κ < σ, V^con_m < V^sp_m ⇒ d^con_0 > d^sp_0. ### Implementation via prudential instruments - Pigouvian tax τ on debt inflows to close wedge between private and social valuations: - Private Euler with tax: σ(1−τ) / d_0 = V^con_m(·). - To replicate planner: set 1 − τ = V^con_m / V^sp_m (equation (13)); since V^sp_m > V^con_m > 1, τ > 0. - Unremunerated reserve requirement u imposing opportunity cost equal to τ: - If cost of capital is r, then u = τ / r = (1 − V^con_m / V^sp_m) / r (equation (14)). ### Quantitative evidence and calibrated results (exchange rate externalities) - Korinek (2010a): externalities of dollar debt in Indonesia ranged from 0 to 30.7% over past two decades; optimal tax on average 1.5%. - Bianchi (2011): optimal tax in calibrated Argentina model ranges 0 to 23%, average 5.2%. - Korinek (2011b): multi-country DSGE finds optimal tax of 2% on average; strongly pro-cyclical: for each percentage point increase in capital inflows/GDP, optimal tax should be raised by 0.87 percentage points. - Aizenman (2011): optimal to tax borrowing at 0.6% and use some revenue to subsidize banking system reserves. - Prudential taxes are highly cyclical (Jeanne and Korinek (2010b); Bianchi and Mendoza (2011)): tighten during booms and relax at troughs. - Caveat: if constraints are always binding (corner), prudential taxes may have no effect (Nikolov (2011); Jeanne and Korinek (2010b) under high impatience). ### Indonesia 1997/98 pecking order (Table entries preserved) - Dollar debt — Real gross return in 1998: 218% — Externality: 30.7% — Optimal tax: 1.54% - GDP-indexed dollar debt — Real gross return in 1998: 190% — Externality: 26.8% — Optimal tax: 1.34% - CPI-indexed rupiah debt — Real gross return in 1998: 100% — Externality: 14.1% — Optimal tax: 0.71% - Rupiah debt — Real gross return in 1998: 63% — Externality: 8.9% — Optimal tax: 0.44% - Stock market index — Real gross return in 1998: 44% — Externality: 6.2% — Optimal tax: 0.31% ### Policy interpretation - Dollar-denominated short-term debt imposes largest externalities due to depreciation effects. - Prudential capital controls (Pigouvian taxes or URRs) can internalize externalities, reduce over-borrowing, and moderate amplification. - Optimal policy is generally pro-cyclical; effectiveness requires borrowing decisions to be interior (occasionally binding). --- ### 4.4 Implementation: Instruments, Effectiveness, and Caveats ### Instruments and equivalence - Pigouvian taxation of capital inflows: transparent, raises revenue, offsets distortion. - Unremunerated reserve requirements (URRs): require part of inflow held in non-interest-bearing reserve; opportunity cost functions as a Pigouvian tax. - Korinek (2010b) notes opportunity cost of holding reserves can be near zero in low global interest-rate environments and fluctuates with global rates. - Price (tax) vs quantity (limits) regulations: - Duality holds under strong homogeneity; breaks down with heterogeneity (Weitzman (1974) logic). - Perotti and Suarez (2011): if banks differ in credit opportunities → price controls desirable; if differ in gambling incentives → quantity controls desirable. - Practical implication: combination of taxes and quantity controls may be constrained optimal. ### Desirability and effectiveness - Forbes (2005) critique: capital controls increase cost of finance and invite evasion. - Counterpoint: raising private cost to reflect social cost is the purpose; changes in composition of flows are evidence of effectiveness if not merely relabeling. ### Caveats - Badly designed measures can slow capital market development; well-designed measures may improve stability and development. - Regulatory measures are prone to circumvention; enforcement/administration investments may be required. - Announcement effects can provoke adverse market reactions if measures are not clearly communicated. ### Extensions overview - Trade-offs and interactions: - Ex-ante prudential controls vs ex-post crisis interventions. - Distortions to real investment and growth from financial amplification. - Role of global interest rates in setting prudential controls. - Cross-border externalities and need for global coordination. ### Prudential capital controls vs ex-post intervention (selected findings) - Optimal policy uses mix of ex-ante and ex-post measures. - Benigno et al. (2010, 2011): ex-post policies that shift labor to tradable sector can appreciate exchange rate and relax constraints; desirable when constraints bind. - Jeanne and Korinek (2011b): combining prudential and ex-post instruments is often optimal; equalize marginal cost/benefit ratios of instruments. - C ́espedes et al. (2011): when banks hold foreign currency debt, direct government lending to banks is most effective. - Jeanne and Korinek (2011c): prudential taxes accumulated in reserve funds can support asset prices/exchange rates during amplification. ### Prudential capital controls, investment, and growth - Internalizing externalities can improve both stability and allocative efficiency (no hard trade-off). - Distortions include excessive pro-cyclical investment and insufficient counter-cyclical investment. - Caballero and Lorenzoni (2009): booms shrinking tradable sector worsen later depreciation and welfare. - Jeanne and Korinek (2011a): prudential controls slow debt buildup in booms, mitigating busts and yielding higher long-run growth under optimal policy than under free market equilibrium. ### Interest rates, global savings, and fragility - Low global interest rates raise borrowing incentives and vulnerability to amplification. - Drivers include neo-mercantilism, precautionary reserve accumulation, and crisis-driven hot-money flows (Steiner (2011); Korinek (2011b); Korinek and Serven (2010)). ### Prudential controls and international spillovers ("currency wars") - Prudential controls by one country can lower world interest rates, potentially increasing borrowing and crisis risk elsewhere. - Korinek (2011a): if each country optimally regulates its externalities, equilibrium is constrained Pareto efficient; breaks down with non-optimal regulation. - Strategic manipulation of world interest rate via controls can be Pareto inefficient. - Bengui (2011a): when liquidity is a global public good, national regulators may under-provide liquidity; global coordination can avoid free-riding. --- ### 6 Conclusion — Key Takeaways - Capital controls may be desirable to counteract pecuniary externalities from balance sheet effects and financial amplification. - Private participants do not internalize balance sheet effects and thus impose externalities by increasing aggregate financial fragility (excessive debt, risky instruments, short-term dollar debt). - Policymakers should internalize externalities and coordinate actions toward lower financial fragility via capital controls that discourage excessively risky instruments, particularly short-term dollar-denominated debt. - Well-designed prudential capital controls can increase both stability and efficiency. - Limits and open questions remain: - Prudential grounds do not justify controls beyond prudential objectives (e.g., fully closed capital accounts are difficult to justify). - Further research needed on microeconomic breadth of balance sheet effects, ex-post macro policies to reduce prudential burden, and optimal implementation forms for capital controls. *Source: _wp11298 - 2.1, 2.2, 3.1–3.3, 4.1, 4.4, 5, 6* ### 2.1 A Brief History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ### _wp11298 - 2.1 A Brief History ### Overview - Emerging market economies integrated into global capital markets experience boom-bust cycles in international capital flows: strong inflows in good times and reversals that often trigger systemic financial crises. - The paper synthesizes a literature that finds prudential controls on capital flows to emerging economies may be welfare-improving because they reduce the incidence and severity of financial crises and the pecuniary externalities that arise during such crises (Korinek, 2010a). ### Financial amplification: mechanism and consequences - Financial amplification is characterized by a feedback loop: - (1) declining exchange rates and asset prices, - (2) adverse balance sheet effects (declining value of collateral and net worth), - (3) falling aggregate demand. - In the presence of financial market imperfections and balance sheet constraints, shocks that reduce aggregate demand can lead to large, amplified effects on macroeconomic aggregates. - The paper employs the term “financial crisis” as synonymous with financial amplification. ### Pecuniary externalities and distortion of private incentives - Small market participants take exchange rates and asset prices as given, but in aggregate their actions determine those prices and the extent of balance sheet effects; private agents thus neglect the price effects of their actions—these are pecuniary externalities. - Pecuniary externalities induce distortions in financing choices of emerging market agents: - Too much debt, - Excessively risky forms of finance (e.g., foreign currency debt rather than FDI), - Excessively short maturities of debt. - Financial fragility is framed as an uninternalized by-product of external financing, analogous to pollution from driving; aligning private and social costs via Pigouvian-style interventions can restore efficiency. ### Historical evolution of crisis models and implications for capital controls - First-generation models (Krugman (1979); Flood and Garber (1984)): crises blamed on profligate government policies (excessive seigniorage) that make exchange rate pegs unsustainable. - Second-generation models (Obstfeld (1994)): devaluations as multiple-equilibrium phenomena driven by inability or unwillingness to bear costs of defending a peg. - Early third-generation models (McKinnon and Pill (1998); Krugman (2001)): bailout guarantees encourage excessive risk-taking by borrowers. - The East Asian crisis (1997/98) highlighted severe balance sheet effects—short-term foreign currency-denominated debt amplified small shocks into self-reinforcing cycles of depreciation, asset-price decline, and contracting activity. - Formal models of financial amplification emerged (Krugman, 1999; Aghion et al., 2000) and cast balance sheet effects as central to understanding emerging-market crises. - While mainstream economists initially still favored free capital flows, models of balance sheet effects and financial amplification generically involve pecuniary externalities implying that free capital flows can be inefficient. ### Scope and normative focus of the paper - Focus is on prudential capital controls designed to correct economy-wide incentives for excessive risk-taking by emerging-market agents; “prudential” refers to measures imposed to stem buildup of risk before a financial crisis materializes. - Exclusions and clarifications: - Does not cover capital controls on outflows or controls motivated by non-prudential reasons. - Focuses on welfare-maximizing prudential capital controls and excludes political-economy distortions and issues of time consistency. - Emphasizes prudential capital controls (residency-discriminating regulations) rather than other macroprudential tools because international investors’ withdrawals impose exchange-rate-related transfers and pecuniary externalities. - Limits the survey largely to theoretical literature on prudential capital controls (empirical literature and endogeneity issues are noted but not covered in depth). *Source: _wp11298 - 2.1 A Brief History* ### 2.2 Balance Sheet Effects and Financial Amplification ### 2.2 Balance Sheet Effects and Financial Amplification ### Mechanism and feedback loop - Financial amplification arises from a self-reinforcing feedback loop of: - declining exchange rates and asset prices; - deteriorating balance sheets (reduced collateral and net worth); - contracting economic activity (falling aggregate demand). - The loop operates through three elements: 1. Declining Prices - Large adverse shocks to aggregate demand in emerging economies typically lead to exchange rate depreciations and declining asset prices. - Exchange rate depreciations can arise in different model classes: - Real models without money: depreciations switch expenditure toward domestic goods to re-equilibrate the economy (e.g., Krugman (1999); Mendoza (2002)). - Monetary models with passive monetary policy: declines in aggregate demand reduce money demand and therefore depreciate the exchange rate (e.g., Aghion et al. (2001)). - Active monetary policy: domestic demand shocks countered with declines in domestic interest rates, with the effect of depreciating the currency. - Fiscal models: lower aggregate demand implies lower tax revenue and greater need for seigniorage, leading to depreciations (e.g., Burnside et al. (2001)). - Asset price declines may originate from: - Changes in the intertemporal marginal rate of substitution of domestic agents (constrained agents value future payoffs less — e.g., Jeanne and Korinek (2010a,b)). - Reduced investment demand for productive assets; if assets cannot be costlessly transformed into consumption goods, their relative price falls (q-theory of investment — e.g., Mendoza (2010)). 2. Balance Sheet Effects - Exchange rate depreciations and asset price declines reduce collateral and net worth, reducing access to credit. - Credit market imperfections modeled as borrowing constraints or credit spreads. - If domestic agents borrowed in foreign currency, exchange rate depreciation increases the domestic value of debt, producing adverse valuation effects (e.g., Krugman, 1999). 3. Falling Aggregate Demand - Tighter credit reduces consumption and investment, lowering aggregate demand and demand for domestic goods and assets, feeding back to price declines. - Any of the three elements can be the initial trigger: shocks to exchange rates/asset prices (capital outflows, global risk aversion), to balance sheets (unexpected losses, tighter credit), or to aggregate demand (decline in exports, fall in growth). - Capital flows become pro-cyclical under financial amplification: credit relaxes in good times and tightens in bad times, making capital flows destabilizing. - Price movements must be larger than in the absence of balance sheet effects (overshooting): "For every three steps forward that the price movement makes in restoring market equilibrium, the economy slips two steps backward because of adverse balance sheet effects." ### Connections with closed-economy amplification literature - Falling asset prices feature in closed-economy financial amplification (e.g., Fisher, 1933; Bernanke and Gertler, 1989; Carlstrom and Fuerst, 1997; Kiyotaki and Moore, 1997). - Main distinction: open economy models can explicitly account for the exchange rate’s role in causing balance sheet effects. - Empirical evidence suggests exchange rate depreciations are crucial for balance sheet effects during crises in small open economies; emerging economies are particularly vulnerable (Frankel, 2005). ### Stylized model setup for analytic illustration (Korinek-based) - Economy: small open endowment economy, two periods t = 1 and 2. - Period 1 goods: tradable and non-tradable; relative price of non-tradable denoted by p (measure of the real exchange rate). Period 2: only tradable goods. - Representative agent utility: - U = log(c1) + cT,2 - c1 = (cT,1)^σ (cN,1)^{1−σ} - Cobb-Douglas shares σ and 1−σ. - Endowments: - Period 1: (yT,1,yN,1) normalized to (σ,1−σ). - Period 2: yT,2. - World gross interest rate set to 1; no discounting. - Consumer enters period 1 with inherited tradable debt d0 (exogenous shock). Define m = yT,1 − d0 (period 1 net tradable holdings). - Period 1 decision: borrow d1 to carry into period 2. - Budget constraints: - cT,1 + p cN,1 = m + p yN,1 + d1 - cT,2 + d1 = yT,2 ### Financial constraint (introducing balance sheet effects) - Borrowing in period 1 constrained by: - d1 ≤ κ(yT,1 + p yN,1) - κ < σ/(1−σ) - Microfoundation: lenders can seize at most fraction κ of consumer income in period 1, convert non-tradables into tradables at market price p, repatriate proceeds; renegotiation/default leads to this effective collateral constraint. - Interpretation: yT,1 + p yN,1 is international collateral; a decline in p reduces collateral and borrowing capacity — captures balance sheet effects. - Constraint variants in literature: - Constraints depending on current relative prices (current income or current asset prices) — examples: Korinek (2007, 2010a), Mendoza (2010), Jeanne and Korinek (2010b). - Constraints depending on future collateral/prices — examples: Kiyotaki and Moore (1997); Cespedes et al. (2011); Korinek (2010a) appendix. - Key requirement for amplification: a relative price (exchange rate, asset price, interest rate) moves in a direction that hurts constrained agents when an adverse shock occurs, either by directly tightening financial constraints or by producing negative income/wealth effects on constrained agents. - Examples of second-category amplification via income/wealth effects: Krugman (1999), Aghion et al. (2001), Schneider and Tornell (2004); Caballero and Krishnamurthy (2001, 2004); Lorenzoni (2008). ### Model solution highlights - Value function: V(m; yT,1) = max log(cT,1)^σ (cN,1)^{1−σ} + cT,2 subject to constraints. - Market clearing: cN,1 = yN,1 = 1−σ; cT,1 = m + d1. - First-order conditions with shadow prices μ and λ: - FOC (cT,1): σ / cT,1 = μ - FOC (cN,1): (1−σ) / cN,1 = μ p - FOC (d1): 1 + λ = μ - Combining FOC (cT,1) and (cN,1) and using cN,1 = 1−σ gives: - p = cT,1 / σ - Thus the real exchange rate p is an increasing function of tradable consumption cT,1 (aggregate demand measure). - Loose financial constraints (d0 ≤ κ): - λ = 0, μ = 1 - cT,1 = σ = yT,1 and d1 = d0 - p = 1 - First-best allocation denoted fb; Vfb(m; yT,1) = vfb + m; marginal value of liquidity Vfb_m(·) = 1 - Binding financial constraints (d0 > κ): - d1 = κ [ yT,1 + p yN,1 ] - cT,1 = m + d1 - Constrained consumer utility: - Vcon(m; yT,1) = vcon + σ log{m + d1} − d1 - Marginal value of liquidity: Vcon_m(·) = σ / cT,1 - Since cT,1 < σ when constrained, Vcon_m > Vfb_m (marginal value of liquidity is higher when constrained). - Equilibrium relationships: - Using p = cT,1 / σ, we obtain: - d1 = κ [ yT,1 + yN,1 · cT,1 / σ ] - Solving equilibrium yields: - d1 = κ· (σ yT,1 + m yN,1) / (σ − κ yN,1) - cT,1 = σ· (m + κ yT,1) / (σ − κ yN,1) - With d0 > κ, constrained d1 and cT,1 are less than unconstrained levels. - Financial amplification effect (response to marginal change in m): - dcT,1/dm = σ / (σ − κ yN,1) > 1 - An increase in m leads to an amplified increase in consumption because higher m increases cT,1, appreciates p, relaxes borrowing constraint, and further raises cT,1. ### Pecuniary externalities and policy implications (overview) - Exchange rate depreciations and asset price declines during financial amplification entail pecuniary externalities. - The text outlines a plan to: - define externalities (pecuniary vs. technological); - discuss when pecuniary externalities are consistent with Pareto efficiency and when they cause distortions that justify policy intervention; - formalize insights within the analytical model above; - discuss implications for capital inflows in emerging economies and the desirability of prudential capital controls. *Source: _wp11298 - 2.2 Balance Sheet Effects and Financial Amplification* ### 3.1 Pecuniary Externalities and Efficiency ### 3.1 Pecuniary Externalities and Efficiency ### Definitions and basic distinction - Externalities are defined as indirect effects of an economic activity on agents other than the originators of such activity. - Two types of externalities: - Technological externalities: direct effects on the utility function or the production function of another agent (example: pollution). - Pecuniary externalities: arise when an economic activity affects relative prices and this has an indirect effect on the welfare of another agent by changing her consumption set or her production set; they work through the price system (example from Laffont (1987): increased whiskey consumption raises whiskey prices, benefiting producers and hurting other consumers). - In an economy with complete markets and price taking behavior, the first fundamental theorem of welfare economics implies the decentralized equilibrium is Pareto efficient despite pecuniary externalities (footnote 9: an additional technical condition is that the preferences of all agents need to be locally non-satiated). - Relative prices reflect relative marginal utilities for all goods and agents, so gains to sellers are precisely offset by losses to buyers; price changes “net out” and the new equilibrium remains Pareto efficient. ### Pecuniary externalities under incomplete markets and noncompetitive behavior - The term “pecuniary externalities” is used for any indirect welfare effects that one agent imposes on another through the price system, regardless of market completeness. - Pecuniary externalities are part of normal market functioning: any change in demand or supply that moves prices generates income and wealth effects (plus substitution effects) that equilibrate markets. - Pecuniary externalities are associated with inefficiencies when conditions of the first welfare theorem are violated: - When agents exert pricing power (noncompetitive behavior), they internalize pecuniary externalities partially and find it optimal to reduce trade; result: inefficiently low transactions and a monopoly wedge between marginal valuations of buyers and sellers. - When markets are incomplete, agents cannot equalize marginal utilities across all goods, times, and states of nature; price movements then generate pecuniary externalities that generally do not cancel out and the decentralized equilibrium is not constrained Pareto efficient (references: Greenwald and Stiglitz, 1986; Hart (1975); Stiglitz (1982); Geanakoplos and Polemarchakis (1986); Arnott et al. (1992)). ### Example: borrowing constrained market and amplification - In the analytic example, borrowing is limited by the value of the borrower’s collateral. When the borrowing constraint is binding: - The borrower values resources today relatively more than the lender; they cannot equate relative marginal utilities. - An appreciation in the exchange rate or an increase in asset prices that raises collateral values relaxes the borrowing constraint and allows more lending, moving the economy closer to the first-best allocation and producing a Pareto improvement. - Externalities can be viewed as a coordination problem: coordinated actions could limit adverse price movements that damage balance sheets in crises, but a free-rider problem prevents decentralised coordination. --- ### 3.2 Pecuniary Externalities in Open Economy Macroeconomics ### Role of exchange rates and asset prices with complete markets - With complete markets, exchange rate depreciations in response to adverse shocks are stabilizing because depreciation is expansionary (competitiveness-enhancing); this underpins arguments for flexible exchange rates (Friedman, 1953). - Asset price declines after adverse shocks signal a need to reduce investment; asset price movements help equilibrate demand and supply for investment. ### When markets are incomplete or borrowing constrained - Exchange rate and asset price movements generate pecuniary externalities (e.g., depreciation raises import prices and creates negative income effects for domestic consumers). - With complete and unconstrained markets, negative income effects on domestic agents are offset by positive effects for foreigners; Pareto efficiency preserved. - With borrowing constraints, domestic agents value consumption relatively more than foreigners (would pay higher interest if allowed to borrow); negative income effects on domestic agents from depreciation are larger than positive effects on foreigners, reducing aggregate welfare. - If exchange rates or asset prices enter the borrowing constraint directly, relative price movements can tighten binding constraints and reduce aggregate welfare; these are closely linked to “balance sheet effects” and financial amplification that make crises costly for welfare. ### Decentralized behavior and potential planner intervention - Decentralized agents take prices (exchange rates and asset prices) as given; small agents rationally recognize limited price impact (footnote 12: even with some market power, agents will not fully internalize pecuniary externalities—example: in a duopoly each player internalizes only 50%). - If amplification effects are present, coordinated use of pricing power to counter inefficient relative price movements would make everyone better off; a planner would internalize these effects. --- ### 3.3 Undervaluation of Liquidity ### Constrained social planner setup - Introduce a constrained social planner who optimizes domestic consumers’ welfare subject to the same constraints as decentralized consumers: borrowing constraint, budget constraints, and market structure constraints. - The planner internalizes that the exchange rate at which non-tradable collateral is valued is determined by the marginal rate of substitution between tradable and non-tradable goods (exchange rate equation (6)). - This constrained planner differs from a first-best planner because she cannot ignore individual borrowing or budget constraints; she represents a realistic regulatory authority. Because the economy is small, domestic welfare improvements are global Pareto improvements. ### Valuation of liquidity: decentralized agents vs planner - When the financial constraint is loose, both decentralized agents and the constrained planner implement the first-best allocation and perceive the marginal value of liquidity as V_fb^m = 1. - When borrowing constraints bind and financial amplification is triggered, decentralized agents undervalue liquidity relative to the constrained planner (Lemma 1). Lemma 1 (Undervaluation of Liquidity) - Decentralized agents in an economy that is subject to financial amplification effects undervalue liquidity compared to a constrained planner. - Equivalently, decentralized agents undervalue the cost of financial payouts when the constraint is binding. Proof sketch and key expressions (as given) - Decentralized agents perceive the benefit of a marginal unit of liquidity when the financial constraint is binding as V_con^m = σ c_T,1. - In general equilibrium substitute for c_T,1 from equation (11) to re-write: - V_con^m(·) = σ−κy_N,1 m+κy_T,1 - The social planner internalizes that the exchange rate in (7) is endogenous to aggregate period 1 tradable resources m = y^T − d_0. Using the borrowing limit d_1 from equation (10), the planner’s value function is - V_sp(m;y_T,1) = v_sp + σ log [m+κ y_T,1] − κ· σ y_T,1 + m y_N,1 σ−κ y_N,1 (for an appropriately chosen constant v_sp). - The planner’s marginal benefit of liquidity: - V_sp^m(·) = σ m+κ y_T,1 − κ y_N,1 σ−κ y_N,1 - Comparing marginal valuations: - V_sp^m > V_con^m (Recall that the constraint binds when d_0 > κ and normalization y_T,1 + y_N,1 = 1.) - Interpretation: during financial amplification, decentralized agents only recognize private benefits of additional liquidity (V_con^m), while a constrained social planner internalizes social benefits (V_sp^m) because additional liquidity raises aggregate demand, appreciates the exchange rate, and produces positive financial amplification effects. - A healthy balance sheet (holding liquidity m when constraints bind) is a public good; the planner ensures socially optimal provision. --- ### 4 Financing Decisions and Capital Controls (introductory remarks) ### Central role of marginal valuation of liquidity - The marginal valuation of liquidity determines intertemporal and many intratemporal allocations; it is often referred to as the pricing kernel, stochastic discount factor, or intertemporal marginal rate of substitution. - In the analytic example, planner and decentralized valuations differ but allocations coincide when the financial constraint binds because no decision margins remain. - Introducing additional decision margins reveals distortions from undervaluation (Lemma 1) in decentralized behavior. ### Distortions highlighted - The undervaluation of liquidity creates a range of distortions in financing decisions analyzed in the literature on prudential capital controls (Korinek, 2010a): - Overborrowing - Excessive risk-taking - Excessive short-term debt - The paper characterizes these distortions analytically in the benchmark model and discusses related literature grouped by: - Exchange rate externalities - Asset price externalities - Interest rate externalities *Source: _wp11298 - 3.1 Pecuniary Externalities and Efficiency* ### 4.1 Over-borrowing ### 4.1 Over-borrowing ### Mechanism and main finding - Undervaluation of liquidity (lemma 1) in emerging economies with financial amplification leads to over-borrowing: individual agents do not internalize the full social cost of repayments when financial constraints are binding, so they take on an excessive debt level and promise excessive repayments relative to a constrained planner. - Excessive debt magnifies financial amplification: decentralized agents face sharper declines in the exchange rate and in borrowing capacity than under a constrained planner, producing excessive volatility and less smooth consumption. - Policy implication: it is desirable to impose prudential capital controls on inflows of debt to reduce external borrowing by private agents. ### Analytic illustration (three-period augmentation) - Setup: - Additional period 0 before financial amplification in period 1. - Consumers born with no endowment in period 0 and utility: - U = log(c^σ_{T,0}) + log(c_1) + c^T_2 (equation (12) notation preserved) - Borrowing in period 0: c^T,0 = d_0. - Liquid tradable resources in period 1: m = y^T − d_0. - Consumer problem: max σ log(d_0) + V(y^T,1 − d_0; y^T,1) with first-order condition σ / d_0 = V_m(·). - Result 1 (Over-borrowing): - If κ < σ, a constrained social planner would take on less debt than decentralized agents. - Proof sketch: - If κ ≥ σ, no constraint in period 1 and V^fb_m = 1, d_0 = σ so decentralized and planner allocations coincide. - If κ < σ, economy is constrained; lemma 1 implies V^con_m < V^sp_m, hence d^con_0 > d^sp_0. - Interpretation: the planner smooths consumption by introducing a small wedge between periods 0 and 1 to reduce a larger wedge between periods 1 and 2. ### Implementation via prudential instruments - Pigouvian tax τ on debt inflows that closes wedge between private valuation V^con_m and social valuation V^sp_m: - Private Euler: σ(1−τ) / d_0 = V^con_m(·). - To replicate planner: σ / d_0 = V^sp_m(·) if set - 1 − τ = V^con_m / V^sp_m (equation (13)) - Since V^sp_m > V^con_m > 1, τ > 0 but sufficiently small to avoid fully preventing borrowing (planner reduces magnitude of crises but does not attempt to completely avoid them). - Unremunerated reserve requirement u imposing opportunity cost on lender equal to Pigouvian tax τ: - If cost of capital is r, then u = τ / r = (1 − V^con_m / V^sp_m) / r (equation (14)) ### Quantitative evidence and literature (exchange rate externalities) - Korinek (2010a): - Estimates externalities of dollar debt in Indonesia ranged from 0 to 30.7% over the past two decades. - Finds optimal level of tax should be on average 1.5%. - Uses sufficient statistics approach: externalities determined as product of social cost of borrowing constraints (gap in Euler equation) and extent of amplification (marginal change in debt in response to shock). - Bianchi (2011): - Quantifies optimal tax in a calibrated dynamic model to Argentina: ranges from 0 to 23%, with an average of 5.2%. - Korinek (2011b): - Multi-country DSGE: finds an optimal tax of 2% on average, strongly pro-cyclical: for each percentage point increase in capital inflows/GDP ratio, optimal tax should be raised by 0.87 percentage points. - Aizenman (2011): - Model of fire sale externalities: optimal to tax borrowing at a rate of 0.6% and use some revenue to subsidize banking system reserves. - Prudential taxes are highly cyclical (Jeanne and Korinek (2010b); Bianchi and Mendoza (2011)): - Prudential controls should be raised during booms when risk builds up and relaxed at the bottom of crises; optimal controls adjust pro-cyclically. - Caveat from models with binding constraints always: - If borrowers are calibrated so constraints are always binding (Nikolov (2011); Jeanne and Korinek (2010b) under high impatience), borrowing is a corner solution and prudential taxes have no effect. Insight: frameworks with occasionally binding constraints are needed to study prudential policy based on pecuniary externalities. ### Table (pecking order of externalities and optimal taxes) — Indonesia, 1997/98 (entries preserved) - Table 1 entries (as reported): - Asset category: Dollar debt — Real gross return in 1998: 218% — Externality: 30.7% — Optimal tax: 1.54% - Asset category: GDP-indexed dollar debt — Real gross return in 1998: 190% — Externality: 26.8% — Optimal tax: 1.34% - Asset category: CPI-indexed rupiah debt — Real gross return in 1998: 100% — Externality: 14.1% — Optimal tax: 0.71% - Asset category: Rupiah debt — Real gross return in 1998: 63% — Externality: 8.9% — Optimal tax: 0.44% - Asset category: Stock market index — Real gross return in 1998: 44% — Externality: 6.2% — Optimal tax: 0.31% - Interpretation: - Dollar debt imposes largest externalities due to depreciation inflating dollar liabilities during crises. - CPI-indexed debt, rupiah debt, and equity impose progressively smaller externalities due to varying degrees of risk-sharing and indexing. ### Relation to policy design - Prudential capital controls (Pigouvian taxes or unremunerated reserve requirements) can internalize pecuniary externalities, reduce over-borrowing, and moderate financial amplification. - Optimal policy is generally pro-cyclical: tighten during booms (when risk of binding constraints at repayment is higher) and relax during crises (when no scope for further deterioration). - Policies should account for state-contingency of constraints; effectiveness depends on whether borrowing decisions are interior (occasionally binding) or corner solutions (always binding). *Source: IMF working paper section 4.1 ("Over-borrowing")* ### 4.4 Implementation ### 4.4 Implementation ### Instruments - Optimal policy measures in the literature are often derived as tax wedges that can be implemented in a variety of equivalent ways. - Direct Pigouvian taxation of capital inflows: - Benefit: transparent, raises revenue, and offsets a distortion. - Unremunerated reserve requirements (URRs): - Require international investors to hold part of any inflow in a reserve account that does not earn interest. - The opportunity cost of not receiving interest can be viewed as a Pigouvian tax. - Footnote note: Korinek (2010b) cautions that the opportunity cost of holding reserves in the current economic environment with low global interest rates are close to zero and fluctuate strongly with small changes in global interest rates, making the policy instrument less reliable. (Reference number in source: 18) - Price (tax) versus quantity (limits) regulations: - Duality between price and quantity regulations holds under strong homogeneity assumptions (e.g., a “representative” borrower). - When agents are heterogeneous or the environment is uncertain (Weitzman (1974) logic), price–quantity duality can break down. - Perotti and Suarez (2011) on banking regulation with uniform rules across heterogeneous banks: - If banks differ mostly in credit opportunities → price controls are desirable (allow optimal portfolio size adjustments while offsetting pecuniary externalities). - If banks differ mostly in gambling incentives → quantity controls are desirable (prevent the most “reckless” banks from taking excessive quantities of credit). - Practical implication: both dimensions of heterogeneity are relevant → a combination of taxes and quantity controls may be constrained optimal. - Application to prudential capital controls: - If recipients differ mostly in profitability → price-based controls desirable (allocates capital to more profitable agents). - If recipients differ mostly in riskiness → quantity controls (e.g., limits on leverage) may be optimal. - Practical implication: a combination of price and quantity measures may be desirable; further research is needed. ### Desirability and Effectiveness - Forbes (2005) critique: - Argument: prudential capital controls may be undesirable because they increase the cost of finance for private firms and give rise to evasion. - Counterpoint: raising private cost of capital inflows to their social cost is the goal of such regulation; an increase in private cost for financially constrained agents can indicate effectiveness. - Empirical literature frequently finds that capital controls are successful at changing the composition of capital flows; this change is only desirable if it does not merely constitute a relabeling to circumvent controls on undesirable forms of capital flows. (Reference number in source: 19) ### Caveats - Important caveats to imposing prudential capital controls: - (i) Badly designed measures can adversely affect the pace of capital market development; well-designed measures can improve market development by providing a more stable financial environment. - (ii) Regulatory measures are prone to circumvention; ensuring compliance may require increased investments in enforcement or administration. - (iii) Announcement effects: announcing new capital controls may lead to adverse market reactions if the desirability of such measures is not clearly communicated. ### Extensions (overview of subsequent sections) - The paper extends the basic framework along several dimensions: - Role of ex-ante prudential controls versus ex-post policy interventions to respond to financial crises. - Distortions in real investment and growth from financial amplification. - Implications of global interest rates for the level of prudential capital controls. - Externalities that prudential capital controls in one country may impose on other countries and the role for global coordination. ### 5.1 Prudential Capital Controls Vs. Ex-Post Intervention - General lesson: optimal policy uses a mix of both ex-ante and ex-post measures. - Benigno et al. (2010, 2011): - Introduce a policymaker instrument to shift labor into the tradable sector to appreciate the exchange rate and relax borrowing constraints. - Such policies are desirable when financial constraints are binding to mitigate severity of crises. - Optimal implication: if crises can be mitigated ex-post, emerging economies optimally reduce precautionary saving (increase borrowing) — but normative analysis must compare planner vs. decentralized allocations under ceteris paribus conditions; Atkinson and Stiglitz (1980) logic applies. - Jeanne and Korinek (2011b): - Focus on optimal tax wedges; find desirability of combining prudential and ex-post instruments in a wide range of settings. - Additional ex-post measures include support for declining asset prices; at the optimum expected marginal cost/benefit ratios of all policy measures are equalized. - C ́espedes et al. (2011): - In economies with banks holding foreign currency debt, the most effective government funding use is lending directly to banks (recapitalized banks can leverage and lend multiples of capital), dominating direct lending to firms or indirect bank bailouts via exchange rate intervention. - Jeanne and Korinek (2011c): - Prudential taxes accumulated in a reserve fund can be used to support asset prices or exchange rates during financial amplification, combining prudential taxation and price support. ### 5.2 Prudential Capital Controls, Investment and Growth - Core result: capital controls that internalize externalities can make allocations more efficient and may produce Pareto improvements. - Market distortion: private agents underestimate social cost of losses in bad times (lemma 1), leading to: - Excessive investment in pro-cyclical projects that create costly liquidity shortfalls in constrained states. - Insufficient investment in counter-cyclical projects that deliver socially valuable payoffs in bad states. - Net effect: real payoffs become excessively cyclical. - Implication: the presumed trade-off between financial stability and allocative efficiency (a Pareto frontier) is rejected in these economies prone to financial amplification — proper regulation can enhance both stability and efficiency. - Caballero and Lorenzoni (2009): - Exchange rate booms reduce investment in tradable sector → pecuniary externality: smaller tradable sector implies greater scarcity of tradable liquidity and stronger depreciation of real exchange rate later, reducing consumer welfare. - Policy implication: interventions during booms (e.g., subsidizing tradable capital holdings) or after reversals may prevent excessive shrinkage and help recovery. - Jeanne and Korinek (2011a): - In models with collateralized borrowing and growth-enhancing fixed-asset investment, financial amplification leads to credit crunches that reduce investment and cause permanently lower output paths. - Proper prudential controls on capital inflows slow debt buildup in booms, mitigating busts; although growth is marginally reduced in booms, avoiding severe crises yields higher long-run growth under optimal prudential controls than under free market equilibrium. ### 5.3 Interest Rates and Financial Fragility - Low global interest rates increase incentives to borrow and to take on higher debt, raising exposure to shocks and financial amplification. - Reasons for low interest rates in recent times: - Neo-mercantilism and crises elsewhere in the world economy. - Steiner (2011): precautionary reserve accumulation by some central banks increased global supply of savings, pushed down world interest rate, making deficit countries more vulnerable. - Korinek (2011b): financial crises in one region lead to hot-money outflows to other countries; ensuing higher supply of capital to healthy economies lowers their interest rates and increases vulnerability to future crises. - Korinek and Serven (2010): neo-mercantilism likely contributed significantly to pushing down world interest rates in the most recent decade. ### 5.4 Prudential Capital Controls and Currency Wars - Concern: prudential capital controls in one country may have negative spillovers on other countries (through world interest rate). - Example: a large country imposing prudential controls reduces global demand for capital → ceteris paribus decline in world interest rates → other countries may borrow more and face greater crisis risk. - Korinek (2011a): - If each country optimally regulates the externalities it experiences, resulting equilibrium is constrained Pareto efficient → no need for global coordination. - This result breaks down if countries do not or cannot optimally regulate (e.g., targeting problems). - Strategic manipulation: - If countries impose controls to manipulate the world interest rate (intertemporal terms of trade), equilibrium is Pareto inefficient (monopoly-like): lowering interest rate redistributes income from lenders to borrowers and reduces quantity transacted with negative welfare effects. - Bengui (2011a): - In a multi-country banking and liquidity regulation model where liquidity is a global public good, national regulators may under-provide liquidity (free-ride on other countries). - Global coordination among regulators can avoid free-riding and induce higher, socially efficient liquidity requirements. ### 6 Conclusion (key takeaways) - Literature view: capital controls may be desirable to counteract pecuniary externalities arising from balance sheet effects and financial amplification. - Private participants do not internalize balance sheet effects and thus impose externalities by increasing aggregate financial fragility (excessive debt, risky instruments, excessive short-term borrowing). - Policymakers should internalize externalities and coordinate market actions toward lower financial fragility via capital controls that discourage excessively risky instruments, particularly short-term dollar denominated debt. - Well-designed prudential capital controls can increase both stability and efficiency, making everybody better off. - Limits and open questions: - Prudential capital controls cannot justify controls beyond prudential considerations (e.g., fully closed capital accounts are difficult to justify on prudential grounds). - Further research needed on: - Microeconomic breadth of balance sheet effects during financial amplification. - Macroeconomic policies to deal with financial crises ex-post, reducing burden on prudential policies. - Implementation: which forms of capital controls are most desirable and effective in preventing risk buildup that may cause large financial crises. *Source: _wp11298 - 4.4 Implementation* ### References ### _wp11298 - References ### Full reference list - Aghion, P., Bacchetta, P., and Banerjee, A. 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