Professional Documents
Culture Documents
Price
under Time-varying Degree of
Agency Cost
Nuwat Nookhwun
Research Paper,
Nuwat Nookhwun
1
This paper was written as a part of “Research Paper” subject, taught
in the bachelor’s degree at the Faculty of Economics, Chulalongkorn
University, in the academic year 2008.
2
This paper is an individual study. Any views or findings from this
study do not reflect those of the institutions
3
I would like to thank Pongsak Luangaram, Ph.D. from Warwick
University and lecturer at Chulalongkorn University, for a kind
assistance as an advisor of this paper. He helped me a lot in guiding
the appropriate topic, commenting on the model, and suggesting many
interesting arguments concerning the topic. Moreover, I do admire his
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
Nuwat Nookhwun
March 2009
ABSTRACT
The on-going subprime crisis has again raised the issue
of whether central banks should use monetary policy to
prevent asset price bubble. This paper presents an adapted
version of the theoretical model used by Carlstrom and Fuerst
(2001A) to address this issue. The model is constructed
under the assumption of imperfect credit market which the
entrepreneur’s net worth can affect its ability to produce. The
net worth, in turn, is determined by asset price. The
adaptation of the model involves the assumption that the net
worth is not the only factor determining the firm’s borrowing.
It also depends on the current degree of agency cost. This
paper regards this degree of agency cost as measure of credit
boom and bust.
The results show that there is a welfare-improving role
for a monetary policy that responds actively to asset price,
productivity and agency cost shocks. This activist policy
allows the economy to respond to shocks in an efficient
manner by smoothing the fluctuations in the collateral
-3-
Nuwat Nookhwun
Nuwat Nookhwun
112 Soi Areesampan 2
Paholyothin Rd., Bangkok,
Thailand 10400
nuwat2001@hotmail.com
1. Introduction
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
Depression in the 1930s. The bursting bubble led to a rise in
mortgage delinquency and foreclosure which contributed
many financial institutions to write down their loss from
default and an investment in mortgage-backed securities
(MBS) and collateralized debt obligations (CDO). Financial
crisis eventually occurs, and fear of recession spreads all over
the world. Apart from the role of securitization, poor
performance by credit-rating agencies and lack of regulation
in subprime mortgage market, monetary policy is to be
blamed for that.
The Federal Funds rate was held too low for a long
period with the objective to overcome the recession that was
caused by the burst of DOTCOM bubble together with the
terrorist attack both in the early 2000s. The unusually low
U.S. policy rate caused excessive liquidity and a speculation
in housing market which subsequently led to a bubble. Taylor
(2007) points out that by slashing interest rates by more than
the Taylor rule suggested, the Federal Reserve (FED)
encouraged a house price boom. Though FED has started
increasing the rate since the second quarter of 2004, such
tightening should be implemented since 2002. With a higher
Federal Funds rate, there would have been a much smaller
increase in housing starts. Moreover, Manchau (2007)
suggests that “it is time to learn that main lesson of this
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Nuwat Nookhwun
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
it can be far more painful than what he has previously
imagined. Mishkin (2008) also suggests monetary policy
respond to asset price movement, whether bubble occurs or
not, if and only if it has implications for inflation and output.
Apart from those reasons made by Kohn, he believes
monetary policy actions are a very blunt instrument because
they would be likely to affect prices in general, rather than
those in a bubble. That creates a further distortion in the
economy. Besides, he supports regulatory policies and
supervisory practices to help strengthen the financial system
and reduce its vulnerability to asset price cycle. Indeed, his
view is in accordance with the present FED governor, Ben S.
Bernanke.
Therefore, the continually debating issue of whether
monetary policy should respond to asset price and asset price
bubble is still controversial nowadays. This paper presents an
adapted version of the theoretical model used by Carlstrom
and Fuerst (2001A) to address this issue. The model is
constructed under the assumption of imperfect credit market
which allows the linkage between the movement in asset
price and output. Under imperfect credit market, the amount
of funds each entrepreneur received is restricted to its
financial position which is represented by “collateral” or “net
worth”; consequently, increase in its asset price will increase
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Nuwat Nookhwun
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
5
See Mishkin (2008) for an explanation of how asset prices interrupt
inflation and aggregate economic activity.
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Nuwat Nookhwun
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
decisions are also distorted. As equity prices rise, tax
revenues tied to capital gains go up. Increased government
revenue leads to increases in expenditure and cuts in taxes.
With the bubble burst, tax revenues have fallen dramatically.
However, it is impossible to raise taxes, and the result is a
combination of expenditure cuts and increased borrowing, and
ultimately a fiscal imbalance.
Apart from those distortions, bubbles can cause financial
and real economic instability when they burst. Asset prices
can affect value of collateral and thus the provision of credit,
thereby influencing aggregate spending. In case of sharply
falling market valuations, these adverse credit-channel effects
may even be exacerbated by the deteriorating health of banks
and other financial institutions. The on-going subprime crisis
is obviously a good illustration. Therefore, because economies
often fare very poorly after bubbles burst, central bankers
may attempt to control such bubbles to avoid such severe
crisis.
Though bubbles can cause damages to economic
decisions, and financial and real economic stability, there are
reasons why monetary policy should not be used in dealing
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Nuwat Nookhwun
6
This paper summarized 3 opposed arguments based on Kohn (2006,
2008). See those literatures for details and development of those
arguments. 2008 speech revisited the same issue as a result of the
subprime crisis.
7
See Bernanke (2002) for possible indicators of fundamental value.
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
However, given that central banks could identify the
bubbles confidently and market participants would not
quickly arbitrage those mispricing away , timing is still an
8
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Nuwat Nookhwun
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
potential harm bubbles generate. As a bubble is rising,
investors expect very high returns from the increase in asset
prices, sometimes as high as 100% per year. Therefore, a
modest increase in short-term interest rates would have a
limited impact on irrationally exuberant investors. Moreover,
central bank is truly not the only source of liquidity. In the
almost-perfect credit market, investors can depend on external
funding. As a result, aggressive tightening policy may be
needed and that makes ‘‘safe popping’’ impossible because
there is the risk of throwing the whole economy into
recession. Critics of bubble pricking often presented the
example of the 1929 stock market crash which the tightening
monetary policy rapidly led to market crash and dragged the
economy down. Therefore, “mopping up later” might be a
9
better policy.
Many conventional economists also refer that “monetary
policy actions are a very blunt instrument” as there are many
asset prices, and at any one time a bubble may be present in
only a fraction of assets. So, policy actions would be likely
to affect asset prices in general, rather than solely those in a
bubble. Mitigating capital misallocating in one sector would
9
Some economists believe that the stock market decline was more the
result of developing economic weakness (and tight money) than the
cause of the slowdown. See Bernanke (2002) for details.
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Nuwat Nookhwun
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
investors. All these economic and investment decisions do
depend on interest rates and the stance of the monetary
policy. Therefore, the interest rates can affect both credit
conditions and the economic decisions that, in turn, affect
asset prices. The recent experiences of housing bubble in
early 2000s in the United Kingdom, Australia and New
Zealand also suggest that it is possible to react to bubbles
with a moderate and gradual monetary policy tightening
without causing a financial and economic crash. The soft
landing of those economy was so successful.
Indeed, the examples cited by the critics of preemptive
policy, such as Bernanke, are all cases in which the asset
bubble policy management was terrible. In Japan in the
1980s, the Bank of Japan waited too long to deal with the
housing and equity bubbles and too long to ease to deal with
aftermaths. The case of Japan is similar to the US case of
1929 which is a classic example that the FED did not
respond immediately after one official signaled occurrence of
bubbles. Also, in the 1990s technology bubble, the monetary
easing was probably excessive and could reverse earlier and
faster. A less ‘irrationally exuberant’ Greenspan, an earlier
Fed policy of tightening and the use of other instruments to
control leverage could have had an effect on the bubble.
Moreover, most recently, as Taylor (2007) finds out,
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Nuwat Nookhwun
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
In the high-tech boom, for example, the U.S. financial
system remained healthy after the collapse. That obviously
mitigated the real effect caused by bubble burst. In contrast,
the Great Depression in the United States, like Japan’s Great
Recession, did not arise immediately following the asset price
bust because severe banking system distress was combined
with damagingly tight monetary policy over years that output
declined. Kohn (2006) mentions accordingly that the
nonlinear risks associated with a collapsing bubble may
depend on the initial health of the financial system.
Prudential supervision in advance and prompt action to clean
up any problems afterwards would be better way to deal with
bubbles.
Moreover, market corrections can also have severely
adverse consequences if they lead to deflation, as illustrated
by 1929 stock market crash and the experience of Japan. But
it does not follow that conventional monetary policy cannot
adequately deal with the threat of deflation by immediately
mopping up after the bubble collapse. Extra action may
actually exacerbate the problem under the circumstances that
inflation has already started out at a low level.
However, it is confident to say that the costs of recent
subprime crisis have turned out to be gigantic which some
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Nuwat Nookhwun
10
See Kohn (2008). He totally changed his view from previous 2006
speech.
11
Cited from Roubini (2006)
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
Next, I would like to turn to interesting proactive
argument which concerns moral hazard problem. It is correct
to say that monetary policy needs to provide lender-of-last-
resort support to financial markets in the period of liquidity
seizure, following bursting bubbles. But, like any other form
of insurance, such lender-of-last resort liquidity support, while
allowing asset bubbles to grow without doing anything, may
lead to moral hazard distortions. As market participants
believe that central banks would bail them out when the
collapse occurs, they are encouraged to carelessly take risks.
So, in practice, it should have been accompanied by a
willingness to control the rise of bubbles when they do occur.
Critics would argue that an increase in interest rates that
results in less availability of credit would itself increase the
adverse selection problem. To explain clearly, individuals and
firms with the riskiest investment projects are those who are
willing to pay the highest interest rates. If market interest
rates are driven up sufficiently, participants with good credit
risks are less likely to want to borrow. Only bad-credit or
risky borrowers are left in the market. Therefore, there is no
reason to think that in increase in interest rates would punish
the more spendthrift banks and borrowers for their supposed
lack of discipline during the bubble’s expansion.
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Nuwat Nookhwun
12
However, some blame “The Great Moderation” as the cause of the
latest crisis as it may have led many private agents to become less
prudent and to underestimate risks associated with their actions.
Monetary policy is subsequently blamed for contributing to the Great
Moderation. See Kohn (2008).
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
supervisory, lender-of-last-resort approaches to help ensure
financial stability. Specifically, the FED should ensure that
financial institutions and markets are well prepared for the
impacts of a large shock to asset prices. Banks should be
well capitalized and well diversified. The central banks can
also contribute to reducing the probability of boom and bust
cycles occurring in the first place, by supporting more-
transparent accounting and disclosure practices and working
to improve the competence of investors. During the crisis, the
central banks should provide ample liquidity until the
immediate crisis has passed. However, Cecchetti (2004) still
claims that until the efficacy of alternatives is proven, interest
rates are the only tool and the right response to emerging
price bubbles is to raise interest rates.
Considering again the monetary policy, though those
debates above suggest that in practice there are both
agreements and disagreements in conducting preemptive
monetary policy, however if focusing on the theoretical
literatures, many analytical models seem to support the role
of such policy ; some particularly support a non-linear one.
13
13
See Roubini (2006) for other theoretical literatures supporting
preemptive policy. See also Posen (2006) for alternative views.
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Nuwat Nookhwun
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
Mishkin (2008) points out that some asset price bubbles can
have more significant economic effects, and thus raise
additional concerns for economic policymakers, by
contributing to financial instability. He interestingly reveals
the following typical chain of events.
“…Because of either exuberant expectations about
economic prospects or structural changes in financial markets,
a credit boom begins, increasing the demand for some assets
and thereby raising prices. The rise in asset values, in turn,
encourages further lending against these assets, increasing
demand, and hence their prices, even more. This feedback
loop can generate bubble, and the bubble can cause credit
standards to ease as lenders become less concerned about the
ability of the borrowers to repay loans and instead rely on
further appreciation of the asset to shield themselves from
losses. At some point, however, the bubble bursts. The
collapse in asset prices then leads to a reversal of the
feedback loop in which loans go sour, lenders cut back on
credit supply, the demand for the assets declines further, and
the prices drop even more. The resulting loan losses and
declines in asset prices erode the balance sheets at financial
institutions, further diminishing credit and investment across a
broad range of assets. The decline in lending depresses
business and household spending, which weakens economic
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Nuwat Nookhwun
14
Trichet (2005), interestingly, views that it is possible that asset
price bubbles moderate the effects of financial market frictions, like
credit constraint, and improve the allocation of investment. But it
should not be at the expense of a stable financial system.
15
See Mishkin (2008) for full explanation of each crisis.
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
ratio of bank loans to gross domestic product surged and also
a financial deregulation which increases banks’ risk-taking
behavior. The subsequent decade after the bubble burst have
been termed the lost decade. Japan’s experience suggests the
importance of regulatory policies that prevent feedback loops
between asset price and credit provision. During the boom,
Japanese regulation that allowed banks to count as capital
unrealized gains from equities might have contributed to
banks’ appetite for equities during the run-up and to financial
instability when the market collapsed. The on-going
hamburger crisis, named after its origin, really confirms the
role of credit expansion during asset price bubbles. The
securitization process made ample liquidity available in many
markets especially the bubbled subprime mortgage market.
The lenders began to ease standards as further appreciation in
house prices was expected. The process also linked the
unjustified mortgage market to worldwide financial market
through securitized product, for example the MBS and the
CDO, while investors of those products failed to investigate
risks. Once the subprime market collapsed, the financial
market was dragged down and eventually real economy falls
into recession.
In the statistical view, Trichet (2005) cites two
academic literatures on early warning signals which conclude
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Nuwat Nookhwun
16
Mishkin (2008) infers that credit condition can help identify
bubbles. When asset prices are rising rapidly at the same time that
credit is booming there may be greater likelihood that they are
bubbles.
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
examples. The rise in asset values that accompanied with a
boom must not result in higher capital buffers at financial
institutions, supporting further lending. Another one is that
capital requirements may be adjusted over the business
cycles. Moreover, regulation and prudential supervision must
address concerns about risk-taking behavior which are one of
major causes of the many crises.
Concerning monetary policy instruments, Disyatat
(2005) proposes targeting both, which he refers as the cause
of financial imbalances, explicitly in the central banks’ loss
function. He cited the main concern of the proactive view is
that the economy could be left to grow at an unsustainable
pace if monetary authorities do not respond to developing
financial imbalances, and finally could have adverse
consequences for the goals of policy when they implode.
Thus, monetary policy should help lower the probability of a
disruption occurring in the first place. As a result, there must
be an explicit consideration for financial imbalances in the
loss function of the central bank, in addition to that of output
and inflation. The measure of financial imbalances adopted
by the authorities is assumed to be weighted average of asset
prices and household debt, the latter reflecting primarily bank
credit extension. Therefore, this literature moves another step
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Nuwat Nookhwun
both asset price bubble and credit boom. The link to asset
price can easily be described by considering interest rate as
the opportunity cost of holding assets, thus lowering the
policy rate results in higher demand in asset market, and thus
asset prices.
In considering the effect to credit provision, asymmetric
information problem in the credit market is addressed. There
are two basic channels which the policy operates through.
The first one is the balance sheet channel which operates as
follow. Expansionary policy, which causes a rise in asset
prices, raises the net worth of firms and so leads to more
loans available because of the decrease in adverse selection
and moral hazards problems. The other one is the cash flow
channel. It tells us that expansionary policy causes an
17
See Mishkin (2007) for the transmission mechanism of monetary
policy.
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
improvement in firms’ balance sheets because it raises cash
flow from interest payment. The rise in cash flow increases
the liquidity of the firm and thus makes it easier for lenders
to know whether the firm will be able to pay its bill. The
result is that adverse selection and moral hazard problems
become less severe, leading to an increase in lending.
18
Kiyotaki and Moore wrote the related paper in 1997. It is named
“Credit Cycles,” published in Journal of Political Economy.
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Nuwat Nookhwun
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
have on this variable. Moreover, the other important
adaptation of the model is that it can capture the effects
monetary policy has on both asset price and the degree of
agency cost (or credit condition). The previous section has
already described in details their transmission mechanisms.
There will be an implication from the credit channel of
monetary policy when we reach conclusions.
Now, I will start explaining the structure of the model.
This theoretical model consists of 2 representative economic
agents: households and entrepreneurs. I will discuss their
economic decisions thoroughly.
Households’ Behavior
The households are the agents that distribute their labor
supply to entrepreneur’s production. The income received
from working is mainly used for their consumption and
saving. They live infinitely and their period-by-period utility
function is given by
1
1+
Lt
U ( C t , Lt ) = C t −
τ
1 (1)
1+
τ
The utility function is built for simplicity when
analyzing their maximization behavior. The future utility is
discounted at rate β. Ct denotes the households’ consumption
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Nuwat Nookhwun
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
less than one so that the dividend converges to its long-run
average.
The asset trades at share price qt at the beginning of
the period. The asset price depends only on such dividend
process. It is increasing with the current and future dividend
levels, as theory suggests. Its price determination equation
will be found out later. Importantly, I assume that shares
must be purchased with cash accumulated in advance so that
the households have to face the cash-in-advance constraint.
Pt f t ( qt − Dt ) ≤ M t − Bt (3)
ft is the amount of asset purchase while M is the t
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Nuwat Nookhwun
M t +1 ≤ M t − Pt ct + Pt wt Lt + Bt ( Rt − 1) + Pt qt f t −1 − Pt f t ( qt − Dt )
(4)
Pt is the price of the consumption goods. The
intertemporal budget constraint explains that revenue of the
households is generated from the money held in advance
from the previous period, labor income, bond revenue and the
asset acquired in the previous period. Note that the value of
the asset is determined by the present real price. Within the
period, the revenue of the households is used for
consumption, and saving in form of bond purchase and
acquiring asset. The money left is held in advance to the next
period to purchase asset.
To conclude, the households maximize their lifetime
utility subject to cash-in-advance and intertemporal budget
constraint. Thus, their optimization problem is such that,
1+
1
L
∞ Ct − + λ t ( M t − Bt − Pt f t ( qt − Dt )
τ
t
t 1 (5)
L = ∑ β 1+
t= 0 τ
+ µ t ( M t − Ptct + Pt wt Lt + Bt ( Rt − 1) + Pt qt ft− 1 − Pt ft ( qt − Dt ) − M t+ 1 )
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
µt and λt both are lagrangian multiplier for each
constraint. To maximize their utility, they choose their
consumption, labor supply, bond and asset purchase, and
money held in advance to the next period.
The results of the first-order condition are shown below.
Ct : β t (1 − µt Pt ) = 0
µt Pt =1 (6)
:
1
Lt βt
− Lt + µt Pt wt = 0
τ
(7)
1
Lτt = µt Pt wt
Bt : β t ( − λ t + µ t ( Rt − 1) ) = 0
λt + µt = µt Rt (8)
: β [ − λt Pt ( qt − Dt ) − µt Pt ( qt − Dt ) ] + β µ t +1 Pt +1 qt +1 = 0
t t +1
ft
β t ( λt + µt ) Pt ( qt − Dt ) = β t +1 µt +1 Pt +1 qt +1 (9)
M t +1 : β t ( − µ t ) + β t +1 ( λt +1 + µ t +1 ) = 0
β t ( µ t ) = β t +1 ( λt +1 + µ t +1 ) (10)
Substitute (6) in (7) yields
1
L = wt
τ
t
Lt = wtτ (11)
Substitute (6) and (8) in (9) yields
Rt ( qt − Dt ) = βqt +1
q t Rt = Dt Rt + E t βq t +1 (12)
Substitute (6) and (8) in (10) yields
1 βRt +1
=
Pt Pt +1
βPt Rt +1
Et
Pt +1
=1 (13)
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Nuwat Nookhwun
Entrepreneurs’ Behavior
19
Fisher equation explains that nominal interest rate must rise with
the expected inflation.
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
Turning to the entrepreneurs’ behavior, they too are
infinitely lived and have linear preferences over consumption.
They hire labor supplied by households to operate a constant
return to scale production to produce consumption goods.
Their production function is given by
y t = At H t (14)
where yt is consumption goods produced, At is the
current level of productivity and Ht is the number of workers
employed at a real wage w . Like dividends, the productivity
t
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Nuwat Nookhwun
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
its collateral or net worth. We will denote this collateral as n t
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Nuwat Nookhwun
(17)
Degree of agency cost is also an exogenous AR1
random process. However, it is also determined by the gross
interest rate relative to its threshold. The interest rate is
positively affected to the degree of agency cost. As described
earlier in the previous section, this relationship represents the
credit channel of monetary policy which lower interest rate
results in the extension of loan by lowering agency cost. α
shows the effectiveness of such channel. The economies, that
have a close link between monetary policy and credit stance,
tend to have high α . That is, change in monetary policy
significantly affects credit provision. From the above
equation, too low interest rate for a long period of time can
result in continually high µ which contributes to a long period
t
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
panic, changes in the expected economic outlook and many
more. Financial deregulation poses negative agency cost
shock and increases the value of µt .
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Nuwat Nookhwun
(22)
Now, to prevent accumulation tendency from happening,
I will assume that the entrepreneur consumes its dividends
and fraction of its profits each period:
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
µe q A
C te = et Dt + (1 − γ ) (1 − µt ) et −1 qt + t t −1 t t
wt (23)
Equilibrium
After explaining the behavior of both economic agents,
market equilibrium is next to considered. There are two
markets in this theoretical model, the market for assets and
the labor market. The respective market-clearing conditions
are et + f t = 1 20 and Lt = H t . The equilibrium asset price is
given by q R t t = Dt Rt + E t βq t +1 . As for labor market, equating
labor supply to labor demand and solving for the equilibrium
real wage and employment level yields
τ µ t nt
wt =
wt
1
wt = ( µ t nt ) 1+τ
(25)
(26)
τ
Lt = ( µ t nt ) 1+τ
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Nuwat Nookhwun
Steady-state
We can use the above equations to solve for the steady-
state of the model. Let π denote the steady-state inflation
Pt +1
rate where 1 + π = Pt . Then we have:
βPt Rt +1
(27) Et
Pt +1
=1
1 +π
R=
β
(28) qt Rt = Dt Rt + Et βqt +1
DR
q=
R −β
µe A
(29) et = γ (1 − µt ) et −1 + t t −1 t
wt
γ µA
w=
1 −γ + µ γ
w1−τ
e=
µq
1−τ
γµ A
1 − γ + µ γ
e=
µq
(31) Lt = wtτ
τ
τ
γµA A
L = =
1 −γ +µγ 1
−1
1 + γ
µ
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
From equation (27) derived from the implied path for
inflation, the steady-state gross interest rate is increasing with
the steady-state inflation rate. This is in accordance with the
well-known Fisher equation that describes the relationship of
nominal interest rate and inflation. Equation (28) suggests
that the steady-state asset price is determined by the steady-
state gross interest rate and its steady-state dividend. Higher
dividend yields an increase in the steady-state asset price,
while higher interest rate lowers it as stated earlier that such
rate reflects opportunity cost of asset purchase. Therefore,
monetary policy does affect the share price at the steady
state. However, as the steady-state asset purchase is
negatively related with the steady-state share price as
introduced by equation (30), monetary policy will have no
effect on steady-state net worth. Note that net worth is
equivalent to the multiplication of asset purchase and its
price. As a result, it is also superneutral with respect to
steady-state employment and output.
The steady-state employment is determined by the
steady-state level of productivity and degree of agency cost.
Equation (31) tells us that the more the long-run average
productivity level, the more is the steady-state employment.
Concerning the degree of agency cost, lower steady-state
agency cost causes more steady-state employment because of
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Nuwat Nookhwun
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
(32) Lt = ( µ t nt ) 1+τ
τ
~ τ ~ τ ~
Lt = µt + nt
1 +τ 1 +τ
(33) nt = et −1 qt
~ =e
n ~ +q ~
t t −1 t
µe A
(34) et = γ (1 − µt ) et −1 + t t −1 t
wt
µ t At
et = γet −1 (1 − µ t ) +
1
( µ n
t t ) 1+τ
~ τ ~ 1
et ≈ ~
et −1 + µ~ +A − ~
n
1 +τ 1 +τ
t t t
(37) q t Rt = Dt Rt + E t βq t +1
~ +R~ R −β ~ β~
q t t = Dt + Et q t +1
R R
(38) µt +1 = (1 − ρ µ ) µ ss + ρ µ µt − α ( Rt +1 − R ) + ε tµ+1
~ =ρ µ
~ αR ~ ~ µ
µ µ t −1 − R + εt
t
µ t
21
The value of is approximated by implementing the mathematical
~
et
22
The calculation of (37) and (38) involves total differentiation
approach.
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Nuwat Nookhwun
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
lower degree of agency cost (or higher µ ). The important
t
5. Shock Experiments
By combining, we obtain
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Nuwat Nookhwun
~
Lt +1 =
1 +τ
(
τ ~ ~
Lt + At ) (39)
Employment responds with a lag to shock to
productivity. Though the entrepreneur may want to employ
more workers as a result of higher productivity level as it
can generate more profit from that, it cannot because the
employment is subject to the entrepreneur’s present net worth
which depends on previously-acquired asset. However,
increase in productivity can boost next period’s employment
as it increases firm’s output and profit, even if the number of
workers is unchanged. It enables the firm to purchase more
assets. Therefore, net worth is higher in the subsequent
period and that enables the entrepreneur to borrow more to
hire additional workers. Moreover, such effect is persistent.
Though the shock to productivity lasts only one period, the
effect on employment and thus on output lasts much longer
τ
and only dies out at the rate given by 1 +τ . If the shock to
productivity is serially correlated, this effect remains, so that
the collateral constraint prolongs the effect of the productivity
shock.
Output
Positive
and Asset
Productivity
profit purchase rises
Shock
Employment increaseis
Constraint Net worth
improves relaxed increases
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
By combining, we obtain
~
Lt =
τ ~
1 +τ
(
Lt −1 + ε~t D ) (40)
Despite the fact that employment does not respond
immediately to productivity level, it can respond to dividend
shocks contemporaneously. Once there is an innovation in
dividend, change in asset price occurs and thus net worth is
revised in the period shock takes place. Then the entrepreneur
could adjust its labor demand in accordance with its net
worth. The positive shock to dividend results in an increase
in employment as the collateral constraint is relaxed. Besides,
like productivity shock, the effect from shock to dividends is
also persistent.
By combining, we obtain
τ ~ + ε~ µ + τ L
~
Lt =
1 +τ
(
ρµ µt −1 t
1 +τ
~
)
t −1 (41)
Like dividend shock, shock to degree of agency cost
affects employment contemporaneously because such shock
alters firm’s ability to borrow and employment respectively.
Negative shock to degree of agency cost resulting in higher
µt enhances firm’s borrowing in the period shock occurs and
finally, employment improves. These effects are persistent
through two channels. The first channel operates through the
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
lagged effect of agency cost shock as the degree of agency
cost is serially correlated, thus it remains higher than its
steady state for some range of time, and benefiting firm’s
borrowing. Meanwhile, the other one involves continually
higher asset purchase resulted from increases in employment
and profit. Therefore, the effects are highly persistent. Lower
agency cost can result in a period of credit boom which
employment is benefited from that. On the other hand, the
positive agency cost shock, such as financial crisis, could
take times harming the economy before returning to a normal
situation.
Negative Agency
Cost Shock
is higher than
Higher
its steady state
Constraint is
for some range Net worth
relaxed
of time. Employment increases
Asset
improves
Output and ppurchase rises
profit increase
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Nuwat Nookhwun
~ R −β ~ β~
From t +1 , we have q t = −Rt .
~ +R ~ ~
q t t = Dt + Et q
R R
αR ~ αR ~
And From µt +1 = ρµ µt − µ Rt +1 + εt +1 , we have µt = ρµ µt −1 − µ Rt
~ ~ ~µ ~ ~
.
Proceeding as before, we have
~ τ ~ τ ~ τ ~ τ ~ τ ~ τ ~ αR ~
Lt = et −1 + qt + µt = et −1 − Rt + ρµ µt −1 − µ Rt
1 +τ 1 +τ 1 +τ 1 +τ 1 +τ 1 +τ
~ τ ~ 1 ~ τ ~ τ ~ 1 ~ τ ~ αR ~
et = et −1 − qt + µt = et −1 + Rt + ρµ µt −1 − µ Rt
1 +τ 1 +τ 1 +τ 1 +τ 1 +τ 1 +τ
By combining, we obtain
τ ~ αR ~ ~
(42)
~ ~
Lt = Lt −1 + Rt −1 − 1 + Rt + ρµ µ
1 +τ µ t −1
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Nuwat Nookhwun
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
constraint in the world with imperfect credit markets. The
employment Lt = wtτ is left too low because w
t < At as a result of
such constraint. Importantly, it suggests that employment
should respond to productivity level, not to any other types
of shock. But, from the shock experiments above, the
contemporaneous employment does not respond to
productivity shock while responding to other types of shock.
Consequently, the collateral constraint causes the economy to
under respond to productivity shock, and over respond to
dividend and agency cost shocks. The economy really
responds inefficiently to shocks and that does not benefit the
social welfare.
Now we are interested if monetary policy can improve
on this economy’s ability to respond to shocks. As we have
learnt from the steady state that there is no unique optimal
long-run interest rate, monetary policy may have a role in
stabilizing the economy in the short run. The appropriate
adjustment that is welfare-improving occurs when
(45)
~ ~
Lt =τAt
(46)
~ 1 ~ ~
At = ( µt + et −1 + q~ )
1 +τ
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Nuwat Nookhwun
(48)
~
~ = (1 + τ ) A
q t − ( e~ + µ
t
~ )
t −1 t
function yields
~
Rt =
µ
µ +α(R − β)
R − β ~
( )
R − β ρA ~ β ~
R Dt + ρ µ µ t −1 + ε t + et −1 − (1 + τ ) R At − Et R µ t +1
~ ~µ ~
αR ~
Further substitute yields
~ =ρ µ
µ ~ ~µ
Rt +1 + ε
t +1 µ t − t +1
µ
( )
R− β ~ ~ R− β A ~
R Dt + et− 1 − ( 1+ τ ) R At
ρ
~ µ
Rt =
µ + α ( R − β − β µ ) R − β − β µ ~ ~µ β ~ρ ρ
(49)
α
( )
+ ρ µ µ t− 1 + ε t + Et Rt+ 1
µ
R
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
Assume that the discount factor and the autoregressive
coefficient are both low so that is always positive.
R − β − βρµ 23
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Nuwat Nookhwun
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
for example, the financial crisis or panic, a continuously
lower interest rate policy should be implemented as it take
times for agency cost to return to its steady-state level.
Nevertheless, if the policy interest rate lowers by enough to
keep agency cost at the steady state level before the crisis or
panic occur, there will be no need for future course of policy
interest rate.
Fourth, there is an obvious danger to a policy with very
low average nominal interest rates or worse, near a zero
bound. The optimal policy requires an ability to move the
nominal rate adequately in response to shocks. As the
average nominal rate approaches the zero bound, this
flexibility is lost. In this model with collateral constraint, the
Friedman rule would be detrimental as the central bank
24
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Nuwat Nookhwun
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
monetary policy can provide significant impact on credit
provision.
7. Conclusions
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Nuwat Nookhwun
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
movement results in an inefficient dynamic of the economy
which monetary policy must act to stabilize.
In addition to asset price shock, shock to the degree of
agency cost requires monetary policy to respond counter-
cyclically as well. The model really proves the need to be
aware of agency cost shock because when shocks appear,
they can be highly persistent and contribute to a long period
of credit boom or contraction which inefficiently affects
employment and output. Therefore, the model can capture the
evidence in the real world where credit boom and bust can
trigger an unsustainable development of the economy.
Specifically, as discussed earlier, the credit boom, when
accompanied by asset price bubble, is a threat to the
economy. They could generate a collateral-induced credit
crunch, financial crisis, and eventually economic slowdown
when reversals occur. Thus, it is important for monetary
authorities to be aware of such coincidence. In the context of
this theoretical model, both affect employment and output in
an inefficient manner. If they occur simultaneously,
aggressive monetary policy tightening may be required to
control them. However, when there are reversals which lead
to asset price bust and credit crunch, aggressive monetary
policy must be implemented.
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Nuwat Nookhwun
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
should include the feedback loop Mishkin (2008) explains.
Credit boom and asset price bubble support each other in
their occurrence and pose significant risks to financial market
when their reversals take place. The role of such feedback
loop could make this theoretical stylized model more realistic
and have some implications for monetary policymakers in
making policy decisions. My view here is that under the
model with such loophole, if the coincidence occurred,
monetary policy might respond to it less aggressively as
reduction in asset price would help depress collateral-induced
credit boom and credit contraction, in turn, helps lower
demand for asset.
Moreover, it would be interesting if the future study
conduct a numerical simulation of the parameters in this
model. That would enable us to know the exact size of
policy response to shocks. We can also study an appropriate
policy response to shocks under different economies or the
same economy but with different circumstances. Recall that
one term in the policy reaction function has been assumed to
be positive. Thus, the numerical simulation would contribute
to a deep investigation of such term and actually, it might
turn negative in some cases.
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Nuwat Nookhwun
8. References
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
Carlstrom, Charles T., and Timothy S. Fuerst (2001A).
“Monetary policy in a world without perfect capital markets”,
Working Paper 0115, Federal Reserve Bank of Cleveland,
October.
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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
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