Lending Rate Spread Shock and Monetary Policy Arrangements: A Small Open Economy Model for ASEAN Countries

• Published date: 01 March 2014
• DOI: http://doi.org/10.1111/asej.12023
• Date: 01 March 2014
• Author: Taiyo Yoshimi

Lending Rate Spread Shock and Monetary

Policy Arrangements: A Small Open Economy

Model for ASEAN Countries*

Taiyo Yoshimi

Received 14 June 2012; accepted 30 September 2013

We investigate the welfare implications of monetary policy arrangements in a small

open economy, considering firms’ bank-based finances that are widely observed in

emerging ASEAN countries. The impact of an unexpected change in the lending

rate spread, or a lending rate spread shock, depends on the presence of banking

activity in the economy. This presence is important in Malaysia and Vietnam,

where welfare effects of this type of shock are at least comparable to those

of foreign monetary policy shocks. We also find that a rigid exchange rate

arrangement amplifies the effect of a shock.

JEL classification: E52, F33, F41.

Keywords: small open economy, lending rate spread, monetary policy, ASEAN.

doi: 10.1111/asej.12023

I. Introduction

It is widely recognized that monetary transmissions crucially depend on the state

of financial market development and the ways firms handle their external

finances. In countries that lack well-functioning securities markets, credit chan-

nels are important. This tendency is observed in the vast majority of emerging

countries, and ASEAN is a good example. For instance, Subhanij (2010) finds

that firms’ external finances in ASEAN countries are still bank-based, although

the roles of capital markets and non-bank financial institutions have become

increasingly important. Furthermore, studies such as Chua (2003), Cull and Pería

*Department of Economics, Nanzan University, Nagoya, Aichi 466-8673, Japan. Email:

yoshimi@ic.nanzan-u.ac.jp. I have benefited from discussions with and the comments of Hiroshi

Gunji, Kenji Iwata, Vu Tuan Khai, Shigeto Kitano, Chikafumi Nakamura, Eiji Okano, Eiji Ogawa and

Tsutomu Watanabe. I would also like to thank the seminar participants at Hitotsubashi University, the

Research Institute of Capital Formation, the Development Bank of Japan and Thailand Development

Research Institute, and the participants at the Regular Meeting of Nanzan Academic Society in

December 2010 and October 2011, the Chubu area study group meeting of the Japan Society of

Monetary Economics in March 2011, the Nagoya Macroeconomics Workshop in March 2011, the

Nagoya International Economics Study Group in October 2011, the annual meeting of The Japan

Society of International Economics in October 2011, the fall Meeting of the Japanese Economic

Association in October 2011, and the Dynamic Stochastic General Equilibrium (DSGE) Conference

in December 2011. All remaining errors are mine. This work was supported by a Japan Society for the

Promotion of Science Grant-in-Aid for Young Scientists (B) (24730280).

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(2007) and Rajan and Gopalan (2009) find that the share of assets held by foreign

banks is around 10 percent of total banking sector assets on average in emerging

Asian economies. Moreover, shares have not increased remarkably, although the

restrictions on foreign bankers’ participation were eliminated in most countries

after the Asian financial crisis of the late 1990s. This contrasts with the averages

of other emerging nations, such as Central and Eastern European Countries

(CEEC) and Latin American countries, which are around 40 percent. This implies

that most firms in ASEAN countries rely on domestic banks for their external

finances. In this research, we investigate the welfare implications of monetary

policy arrangements in a small open economy where firms depend on domestic

bankers for their external finances in order to draw a direct parallel with emerging

ASEAN countries.

Many researchers have previously dealt with monetary policy issues in emerg-

ing ASEAN economies. Devereux et al. (2006) is one of the most influential works

in the literature on this topic. They examine monetary policy in a small open

economy with lending constraints on investment financing and incomplete

exchange rate pass-through, and find that the degree of pass-through affects the

welfare dominance of alternative monetary policy rules. Elekdag et al. (2006)

construct a model considering financial accelerator and external finances denomi-

nated in foreign currency to discuss policy issues in emerging economies. Tanboon

(2008) constructs a model that replicates the economic situation in Thailand.

The difference between these works and ours is the consideration of firms’

bank-based finances. Agénor and Montiel (2008) also consider firms’ bank-based

finances in a small open economy, and obtain analytical insight into several

monetary policy issues. Our approach is more of a basic DSGE numerical inves-

tigation, such as that in Gali and Monacelli (2005) and Faia and Monacelli (2008).

We introduce bank-based finances in a simple way into a standard small open

economy model, and investigate the welfare implications for each ASEAN

country. A variety of models take into account firms’ external finances. To

understand monetary transmissions through so-called cost channels, Ravenna and

Walsh (2006) assume that firms borrow labor costs from intermediaries at the

gross nominal interest rate and find a significant quantitative role of this channel.

We follow Goodfriend and McCallum (2007) and Cúrdia and Woodford (2010)

and posit a simple production function pertaining to the management of lending

activity by the commercial bank. As we assume countries lack well-functioning

securities markets and focus just on bank-based external finances, we prefer their

specification to those suggested in the financial-accelerator literature, such as in

Bernanke et al. (1996).

Furthermore, we refer to the data of emerging ASEAN countries to calibrate

the financial parameters in our model. As well as considering the bank-based

financial behavior of firms, we focus on the effect of a lending rate spread shock,

found to be important by researchers such as Agénor et al. (2008). Agénor et al.

(2008) examine Argentina and discuss the importance of this type of shock for its

business cycle. Neumeyer and Perri (2005), Tchakarov and Elekdag (2006) and

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