Financial fragility, regime change, and monetary policy in an open economy – A model and empirical application to emerging market countries

Abstract

July 20, 2023 (Revised April 15, 2024) The experiences of the 1997–98 Asian Financial Crisis and the 2008–09 Global Financial Crisis encouraged economists to develop new open-economy dynamic finance-macro models. Such models allow for nonlinearities -- to study the effects of contractionary currency devaluation -- in contrast to models of expansionary currency devaluation. The generic dynamic model of the finance-macro link in this paper includes the dynamics of the inflation rates, output gap, and financial variables (credit flows, risk premia, and exchange rates). The theoretical model with nonlinearities shows that there can be resilient or non-resilient outcomes of the dynamics. The level of resilience is however dependent on some empirical vulnerabilities. Relevant empirics show the risk premium is related not only to domestic real macro and financial variables, but also to the exchange rate and the foreign currency reserves. Econometrically, this paper explores the regime-dependent interaction of the output gap and financial variables in a two-regime non-linear Logistic Vector Smooth Transition Auto-Regressive (LVSTAR) model with a logistic-type transition function. This empirical study reveals that the financial variables of emerging economies show regime-dependent responses to external shocks. Therefore, a positive shock to the risk premia in a negative output gap regime entails an exchange rate depreciation, and accelerating contractions. Overall, however, a diversity of EM economies are examined in terms of their response to external shocks and their resilience levels. This research also has implications for international portfolio holdings.