LTVPolicy Simulation in DSGE Model
Iskandar Simorangkir
Nur M. Adhi Purwanto[1]
Abstract
We develop a small open economy DSGE model with financial frictions and banking sector as in Gerali et al (2010). We modified the banking sector balance sheet from Gerali et al’s model to include risk free assets and reserves, in addition to bank’s loan to households and entrepreneurs, as part of bank’s asset portfolio choices. The main focus of the research is to understand the transmission mechanism of LTV ratio requirement policy and how it will interact with monetary policy.
Based on the model simulation, an increase in LTV ratio requirement for households’ lending will lead to an increase in consumption and housing asset accumulation of the constrained households. This will lead to a higher growth of aggregate demand. A higher growth in aggregate demand will increase inflationary pressure and will prompt central bank to increase the policy rate. The same dynamics applied to an increase in entrepreneur’s LTV ratio requirement. Because the increase in GDP caused by the increase in entrepreneur’s LTV ratio requirement is mostly comes from the higher growth of investment, inflationary pressures is not as significant as in the previous case but central bank still need to respond by increasing the policy rate.
Keywords: Macroprudential, LTV, DSGE
JEL Classification:
I.INTRODUCTION
A well-functioning financial system is necessary for an effective monetary policy transmission. Simultaneously, monetary policy can also influence financial system stability through its effect on financial condition and behavior of the financial market. Changes in policy rate will have an effect on how agents in financial markets perceived the future prospect of the economy and will influence their spending/investment decisions. Despite this, Blanchard et al (2010) argues that the policy rate is not an appropriate tool to deal with many financial system imbalances, such as excess leverage, excessive risk taking, or apparent deviations of asset prices from fundamentals. As an example, they stated that increasing policy rate to deal with excessively high asset price will result in undesirably higher output gap. They proposed that macroprudential policy such as cap on loan-to-value ratio to be employed to address these specific financial system imbalances.
Based on the simulation of the model developed in this research, an increase in LTV ratio requirement for households’ lending will lead to an increase in consumption and housing asset accumulation of the constrained households. This will lead to a higher growth of aggregate demand and inflation. In order to increase households’ lending, the bank reduces the amount of risk free asset from its portfolio and will cause an increase in its loan to deposit ratio (LDR). In addition, allocating more assets with higher interest rate will also increase bank’s profit that will lead to an increase in its capital. A higher growth in aggregate demand will increase inflationary pressure and will prompt central bank to increase the policy rate. The same dynamics applied to an increase in entrepreneur’s LTV ratio requirement. Entrepreneurs will increase their consumption and investment because of the increase in funding they acquired from the bank. This will lead to an increase in GDP. Because the increase in GDP is mostly comes from the higher growth of investment, inflationary pressures is not as significant as in the previous case but central bank still need to respond by increasing policy rate.
The second chapter of this paper analyzes the theoretical and empirical literatures related to financial frictions modeling and aggregate commercial bank’s characteristics in Indonesia, and chapter three explains the model that we developed for this research. Estimation and simulation result of the model will be presented in chapter four, while conclusion will close the paper.
II.LITERATURE REVIEW
2.1Financial Friction in DSGE Model
Based on the current literatures, there are two basic approaches that can be utilized to incorporate financial frictions into macroeconomic model: financial accelerator and collateral constraints. Each of these approaches has its own strengths and weaknesses and a growing numbers of literatures are still debating the merit of each approach.
The premise of the financial accelerator framework is that information asymmetry between borrower and lender creates an external finance premium, reflecting the difference between the costs of externally borrowed and internally generated funds. The external borrowing premium varies intensely with borrower net worth and limits agents’ borrowing. Borrowers’ net worth is defined as the value of assets minus outstanding obligations. In good times, borrowers have higher net worth, raising their creditworthiness and lowering external funding costs. Conversely, in bad times, lower net worth reduces creditworthiness, raising borrowing costs. The countercyclical behavior of the external finance premium is the mechanism amplifying and propagating responses of real output and investment to shocks. For example, the initial response of output to a technology shock is amplified by an associated increase in asset prices. The rise in asset prices increases borrower net worth, leading to a decline in the external finance premium, and further boost to spending. The financial accelerator helps to explain observed large swings in investment and hump-shaped output responses to moderate interest rate changes.
Similar to the financial accelerator framework, the shock amplifying effect of asset prices movements that interact with credit market imperfections is also the basic mechanism in the collateral constraint framework. However, in contrast with the financial accelerator, borrower net wealth directly affects borrowing limits instead of indirectly through an external finance premium. In order to provide borrowers with an incentive to repay and for lenders to rent contracts need to be secured by collateral. Durable assets such as lands, housing, or capital usually serve as collateral.
The financial accelerator and the collateral constraint framework originally assumed that borrowers can obtain funds directly from lenders without any financial intermediaries. Introducing a banking sector into macroeconomic models provides an additional avenue for incorporating financial frictions specifically linked to the cost of intermediation.
Most of macroprudential policy instruments work through the balance sheet of banks or borrowers, and an appropriate modeling technique is needed to uncover the relatively unknown effect of these instruments in each agent portfolio choices or spending decisions. Dynamic Stochastic General Equilibrium (DSGE) model with rigorous treatment on the microeconomic foundations describing the behavior of economic agents has been considered to be the appropriate modeling technique for this purpose.[2] Macroprudential policy instruments are aimed to prevent the pro-cyclicality of the financial system, such as cap on loan to value ratio, cap on debt-to-income ratio, countercyclical capital requirement and time-varying reserve requirement. These instruments works through financial intermediaries’ or borrowers’ balance sheet and expected to create a countercyclical mechanism that would lessen the inherent pro-cyclicality of the financial system. Based on this, the existence of financial frictions and explicit balance sheet of financial intermediaries are necessary to properly model the transmission mechanism of macroprudential policy instruments.
Gerali et al (2010) has published a highly cited paper which describe a closed economy DSGE model with credit frictions and borrowing constraints, a monopolistically competitive banking sector and a set of real and nominal frictions as in Christiano et al (2005). In the model, there are entrepreneurs and two types of households: patient and impatient households. The households consume, acquire housing asset and provide labor to entrepreneurs. Entrepreneurs produce undifferentiated intermediate goods using labor supplied by households and capital. Domestic retailers buy intermediate goods from entrepreneurs and differentiate it at no cost. Domestic retailers’ prices are sticky. Housing stock is assumed to be fixed.Patient households deposit their saving in the banks while impatient households and entrepreneurs borrow from the banks. Both borrower agents are subjected to binding collateral constraints that are tied to their durable assets (housing assets for impatient households and capital asset for entrepreneurs). A stylized banks’ balance sheet includes loan to entrepreneurs and loan to household as assets, and deposits and capital as liabilities. Banks accumulate capital from retained earnings and are subjected to capital adequacy requirement set by the central bank. Banks are assumed to have some degree of market power both in deposit and loan market. In the loan market, banks set different rates for households’ and entrepreneurs’ loan. Margins charged on loan rate depend on bank capital-to-assets ratio and on degree of interest rate stickiness in each market.
2.2Indonesia’s Commercial Bank Characteristics
Based on the current literatures that have tried to incorporate the banking sector in DSGE model,it is usually assumed thatcommercial banks’ have a certain amount of market power in deposit and loan market. Empirical researches in Indonesia have proven the existence of this market power. One of them is Purwanto (2009) that conclude that the dynamic of interest rate spread (defined as the difference between weighted average of loan rate and weighted average of deposit rate) in Indonesia’s banking sector are mostly influenced by the concentration level of the banking industry. Herfindahl-Hirschman Index was used to measure Indonesia’s banking industry’s concentration level.Based on panel model estimation using data from the period of January 2002 – April 2009, the decrease in interest rate spread during the period is mostly caused by the increase in competition in the banking sector which is the result of an increase in market share of most banks and a decline in the market share of banks with large asset.
Another assumption that is also utilized in banking sector modeling is the existence of commercial banks’ retail interest rate stickiness relative to the dynamic of the policy rate. From theoretical point of views, this is actually the optimal behavior if the banks are facing inelastic short term loan/deposit demand function which caused by a high switching cost (Calem et al., 2006) or the existence of afixed cost (menu cost) in changing the level of interest rates (Berger dan Hannan, 1991). Other theoretical reason offered by economist for interest rate stickinessis the bank’s motive to maintain a good relationship with its customers by implementing interest rate smoothingto protect costumers from market or policy rate fluctuations. This arrangement will allow banks to set higher interest rates when the policy rate is low (Berger and Udell, 1992).
A rigid response of commercial bank’s retail interest rate to a shock from policy rate can be observed in the impulse response shown in Figure 2.1. This impulse response is based on bivariate VAR system[3]which consist of the following endogenous variables: (1) Policy rate (BI rate)and consumption loan rate; (2) BI rate and loan rate to firm/entrepreneurs (weighted average of investment loan rate and working capital loan rate); and (3) BI rate deposit rate (weighted average of all types of deposit). From Figure 2.1 we can see a very limited short-term response of commercial bank’s retail interest rate to changes on the policy rate, especially for consumption loan rate. Deposit rate and loan rate to firms/entrepreneurs have similar responses. Although the responses of these two interest rates are not as restricted as consumption loan rate, they still have a relatively high stickiness.
Figure2.1 Impulse Response of bivariate VAR system consists of policy rates and commercial bank’s retail interest rates as the endogenous variables
III.The Model
The model that we develop is based on Gerali et al’s (2010). The main modificationsare related tothe implementation of small open economy assumption and the addition of government as one of the agent in the model. The model also incorporates standard DSGE features such as habit persistence in consumption, adjustment cost in investment, sticky prices and sticky wages.
In the model, there are entrepreneurs and two types of households: patient and impatient households. The main difference among these three agents is in their discount factors in which patient households have higher discount factor compared to impatient households and entrepreneurs. The households consume, acquire and accumulate housing asset, pay taxes to the government and provide labor to entrepreneurs. Entrepreneurs produce undifferentiated intermediate goods using labor supplied by households and capital. These goods are then soldto domestic retailers (for domestic market) and exporting retailers (for foreign market). These two agents then differentiate the homogeneous intermediate goods at no cost. Both domestic retailers’ and exporting retailer’s prices are sticky. Final goods producer act as an aggregator that combines intermediate differentiated goods from domestic retailers and from importing retailers for domestic consumption/investment purposes.
Capital goods producers and housing producers utilize goods bought from final goods producers to produce capital and housing asset using technology that are constrained with investment adjustment cost. The existence of adjustment cost made possible the condition in which we have different price level for capital assets, housing assets and consumption goods.
There are two financial instruments that are provided by banks for economic agents in the model: deposit and loan.Economic agentsare facing borrowing constraintif they want to borrow money from the bank. These borrowing constraints are linked to the value of the collateral that they have, which are housing assets for impatient households and capital assets for entrepreneurs. The different in discount factors among economic agents will ensure the condition in equilibrium in which patient households deposit their money in the banks and impatient households and entrepreneurs borrow from the banks.
The banks are operating in monopolistic competitive condition in which they have market power in deciding interest rates for loan and deposit. Loan dispensed by the bank are financed from total deposits acquired by the banks and from their own capital. We modified Gerali et al’s model by adding risk free asset and reserve as part of banks’ asset portfolio choices. Besides borrowing from domestic commercial banks, entrepreneurs and government also can borrow from foreign financial entities.
Households and Entrepreneurs
Patient householdsmaximize their utility function by choosing the level of consumption, the amount of leisure time and the amount of housing assets they acquired .
... (3.1)
The parameter determines the level of external habit formationand areintertemporal, housing preference and labor preference shocks that have an AR(1) dynamics with an iid errors.
Patient householdsrevenue comes from labor income , interest income from deposit , and dividend (they are the owner of banks and retailers). They spend their income to pay taxes to government, consume, acquire housing assets and save the remaining in the form of bank’s deposit. The following is patient households’ budget constraint:
... (3.2)
In the budget constraint equation, consumption and housing asset are multiplied by their prices to get their nominal values. Parameteris the depreciation level of the housing assets own by the households.
Utility function for impatient householdsis very similar to the patient households’:
... (3.3)
To finance their expenditures, besides having revenue from labor income, impatient householdalso borrow from the bank the amount of . Because of this, impatient householdalsohave obligation to pay the previous period loan along with the interest () as part of their expenditures.
... (3.4)
Total amount that can be borrowed by eachimpatient householdis restrictedby the value of the housing assets own by the household multiplied by loan-to-value ratio .
... (3.5)
From microeconomic point of view (1-can be interpreted as the proportional cost of collateral repossession for bank in the case of default. From macroeconomic point of view, the value of determine the amount of loan can be supplied by the bank for a certain household for a certain value of their housing asset. It is assumed that the LTV ratio is not depend on bank’s individual choicesbut a stochastic exogenous process that allow us to study credit-supply restriction to the real sector of the economy.
Theutility function of entrepreneurs is only based on the amount of the consumption,:
... (3.6)
To finance their consumption, entrepreneur produces homogeneous intermediate goods, , with the following production function:
... (3.7)
Whereis the total factor productivity, is the capital utilization rate, is the capital stock and is the labor input.
To pay for their expenditures which include consumption, labor cost for production purposes, capital accumulation, capital utilization rate adjustment cost and payment for the previous period loan, entrepreneurs use revenue from selling their production goods andfrom new loan acquired from the bank (and from foreign financial entities (.
... (3.8)