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Agency costs and asymmetric information in a small open economy: a dynamic general equilibrium model

  • Kunhong Kim
  • Iris Claus

This paper assesses the effects of agency costs and asymmetric information in credit markets. Asymmetric information and agency costs occur whenever lenders delegate control over resources to borrowers, leading to adverse selection, moral hazard and monitoring costs because of the inability to monitor borrowers costlessly. Financial intermediaries can help overcome this imperfect information, leading to a more efficient allocation of resources. Macroeconomic models currently used by policy makers generally disregard credit market conditions. The basis of the analysis follows Carlstrom and Fuerst (1997). The model is extended to an open economy with a floating exchange rate and slowly adjusting goods prices. Moreover, a government and an inflation targeting monetary authority are introduced. The foreign sector is incorporated following McCallum and Nelson (1999). Firms use imported commodity inputs to produce output. They sell the output to domestic and foreign consumers and exports are a function of the real exchange rate and foreign demand. Incorporating a foreign sector has at least two implications. First, an open economy faces the possibility of shocks that originate from the rest of the world. Second, with a floating exchange rate, movements in the relative price of currencies affect the supply and demand of products and factors of production. The framework of the analysis is a dynamic general equilibrium model with microeconomic foundations, where agents’ decisions are derived from optimising behaviour. The model is calibrated for New Zealand. The steady states with and without agency costs are derived and the effects of these costs on business cycle fluctuations are assessed. A decline in the information asymmetry between borrowers and lenders leads to lower agency costs and an increase in the long-run level of steady state capital, investment and output. The presence of agency costs also affects the business cycle and the monetary authority’s response to shocks in the economy. Moreover, the exchange rate is subject to larger cyclical swings in the presence of agency costs, leading to additional substitution effects as imports are a production input. One of the key results in Carlstrom and Fuerst (1997), a hump shaped response of output and investment to a productivity shock, still prevails in the small open economy set-up. The diffrerences in the adjustment paths of the model with and without agency costs following a shock to the economy provide evidence of quantitatively important effects of agency costs and information asymmetries. The finding suggests that macroeconomic models that do not explicitly account for asymmetric information in credit markets provide an incomplete description of the economy.

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Paper provided by Econometric Society in its series Econometric Society 2004 Far Eastern Meetings with number 787.

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Date of creation: 11 Aug 2004
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Handle: RePEc:ecm:feam04:787
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  1. Sebastian Edwards & Carlos A. Végh, 1997. "Banks and Macroeconomic Disturbances Under Predetermined Exchange Rates," CEMA Working Papers: Serie Documentos de Trabajo. 115, Universidad del CEMA.
  2. Obstfeld, Maurice & Rogoff, Kenneth S., 1995. "Exchange Rate Dynamics Redux," Scholarly Articles 12491026, Harvard University Department of Economics.
  3. Carlstrom, Charles T & Fuerst, Timothy S, 1997. "Agency Costs, Net Worth, and Business Fluctuations: A Computable General Equilibrium Analysis," American Economic Review, American Economic Association, vol. 87(5), pages 893-910, December.
  4. Jonas D.M. Fisher, 1998. "Credit market imperfections and the heterogeneous response of firms to monetary shocks," Working Paper Series, Macroeconomic Issues 96-23, Federal Reserve Bank of Chicago.
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  6. Dixit, Avinash K & Stiglitz, Joseph E, 1975. "Monopolistic Competition and Optimum Product Diversity," The Warwick Economics Research Paper Series (TWERPS) 64, University of Warwick, Department of Economics.
  7. Carlstrom, Charles T. & Fuerst, Timothy S., 2001. "Monetary shocks, agency costs, and business cycles," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 54(1), pages 1-27, June.
  8. Bennett T McCallum & Edward Nelson, 2001. "Monetary Policy for an Open Economy: An Alternative Framework with Optimising Agents and Sticky Prices," Discussion Papers 05, Monetary Policy Committee Unit, Bank of England.
  9. Harald Uhlig, 1995. "A toolkit for analyzing nonlinear dynamic stochastic models easily," Discussion Paper / Institute for Empirical Macroeconomics 101, Federal Reserve Bank of Minneapolis.
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  11. Bernanke, Ben S. & Gertler, Mark & Gilchrist, Simon, 1999. "The financial accelerator in a quantitative business cycle framework," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 21, pages 1341-1393 Elsevier.
  12. Hamid Faruqee & Douglas Laxton & Bart Turtelboom & Peter Isard & Eswar Prasad, 1998. "Multimod Mark III; The Core Dynamic and Steady State Model," IMF Occasional Papers 164, International Monetary Fund.
  13. Timothy S. Fuerst, 1994. "Monetary and financial interaction in the business cycle," Proceedings, Federal Reserve Bank of Cleveland, pages 1321-1353.
  14. Frederic S. Mishkin, 1995. "Symposium on the Monetary Transmission Mechanism," Journal of Economic Perspectives, American Economic Association, vol. 9(4), pages 3-10, Fall.
  15. Robert Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report 45, Federal Reserve Bank of Minneapolis.
  16. Huang, Angela & Margaritis, Dimitri & Mayes, David, 2001. "Monetary policy rules in practice: Evidence from New Zealand," Research Discussion Papers 18/2001, Bank of Finland.
  17. Stephen D. Williamson, 1984. "Costly Monitoring, Financial Intermediation, and Equilibrium Credit Rationing," Working Papers 583, Queen's University, Department of Economics.
  18. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  19. F. Brayton & P. Tinsley, 1996. "A guide to FRB/US: a macroeconomic model of the United States," Finance and Economics Discussion Series 96-42, Board of Governors of the Federal Reserve System (U.S.).
  20. Iris Claus, 2007. "The Effects of Bank Lending in an Open Economy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(5), pages 1213-1243, 08.
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