International Outsourcing, Exchange Rates, and Monetary Policy
Journal of Interational Money and Finance , 118, 2021, 102461
Abstract: Firms’ decisions to outsource the production of intermediate inputs abroad depend on the macroeconomic environment set by governments’ monetary and foreign exchange policies, while the relocations of production change liquidity demands in the financial markets and affect policy effectiveness. This paper studies theoretically the interdependence of firms’ sourcing decisions and governments’ conducts of policies. By constructing a two-country, monetary model with segmented financial markets to incorporate the microeconomic foundations of firms’ make-or-buy decisions and highlight the working capital needs of both buyers and suppliers of intermediate inputs, the endogenous adjustments of international outsourcing at both the extensive and intensive margins are examined. It shows that the adjustments at the intensive margin of firms’ sourcing decisions will dampen the effects of temporary monetary shocks under a fixed exchange rate if the firms face low upfront payments to their foreign suppliers. The adjustments at the extensive margin can alter qualitatively the impacts of a currency revaluation and help explain the perverse effect on the trade balance. Implementing the Friedman rule and a fixed exchange rate regime can address both margins so that the socially optimal allocation can be achieved.
[go to paper]

Liquidity Constraints, International Trade, and Optimal Monetary Policy”
The B.E. Journal of Macroeconomics , 20(1), 2020, 20150203
Abstract: The availability of liquidity matters for an economy’s production and trade as firms need working capital to finance their operations. This paper studies the interaction between trade and capital flows operating through the liquidity allocations in the financial markets using a small-open-economy, overlapping-generations model. Working capital requirements distort the intratemporal consumption allocations. International capital inflows help easing liquidity in the domestic credit market, facilitating trade and improving the intratemporal allocation, while distorting the intertemporal allocation of the economy. We show how the government can use the Friedman rule and differentiated consumption taxes to address the tradeoff between the intratemporal and intertemporal distortions and achieve the second best optimum. Imposing a higher tax rate on imports can reduce the international borrowing to imports ratio and enhance the efficiency in using capital inflows to facilitate trade flows.
[go to paper]

The Welfare Implications of Foreign Exchange Intervention
Journal of International Money and Finance , 27(8), 2008, 1360-1382.
Abstract: This paper examines the welfare implications of foreign exchange intervention in a two-country, two-currency, general equilibrium model with limited participation in financial markets and cash-in-advance constraints on transactions. Both sterilized and nonsterilized intervention operations have significant impacts on the allocation of liquidity in international financial markets and therefore affect real economic activities. The welfare effects of shocks to monetary policy, sterilized and nonsterilized foreign exchange interventions are examined and compared. The design of welfare-maximizing intervention policy rules is also discussed.
[go to paper]

Inflation Taxation and Welfare with Externalities and Leisure
(with Jinli Zeng, and Jie Zhang)
Journal of Money, Credit, and Banking , 39(1), 2007, 105-131
Abstract: This paper examines how inflation taxation affects resource allocation and welfare in a neoclassical growth model with leisure, a production externality and money in the utility function. Switching from consumption taxation to inflation taxation to finance government spending reduces real money balances relative to income, but increases consumption, labor, capital, and output. The net welfare effect of this switch depends crucially on the strength of the externality and on the elasticity of intertemporal substitution. While it is always negative without the externality, it is likely to be positive with a strong externality and elastic intertemporal substitution.
[go to paper]

Financial Liberalization and Economic Growth: A Theoretical Analysis of the Transforming Chinese Economy
(with Michael K.Y. Fung and Lijing Zhu)
Pacific Economic Review , 10(1), 2005, 125-148
Abstract: We conduct a theoretical investigation into how financial reforms are affecting the long-run economic performance of the partially reformed Chinese economy. In a model with a dual structure in commodity production and financial repression, allowing the co-existence of a state banking system and an informal credit market and introducing heterogeneity in the transaction technologies of individuals, we examine the interactions between the state banking system and the informal credit market, and the effects of various measures of financial liberalization on individuals’ optimal portfolio choices and the macroeconomic aggregates.
[go to paper]

The Liquidity Effects of Foreign Exchange Intervention
Journal of Interational Economics , 63(1), 2004, 179-208
Abstract: This paper examines the effectiveness of foreign exchange intervention in a two-country, two-currency, general equilibrium model that allows for liquidity effects. Both sterilized and non-sterilized intervention operations have significant impacts on the allocation of liquidity in international financial markets. Whether intervention is successful in moving the exchange rate in the desirable direction depends upon the degree of sterilization of intervention and the intratemporal elasticity of substitution of the consumption goods. The model shows that there exist circumstances in which the response of exchange rate to intervention is ‘perverse’ as documented in the empirical literature.
[go to paper]

Credit Market Imperfections and Exchange Rate Variability
Canadian Journal of Economics , 33(2), 2000, 360-393
Abstract: In this paper a two-country overlapping generations model is presented in which the roles of financial factors in the international monetary transmission mechanism are studied and whether and how the two types of credit market imperfections, limited participation, and costly state verification may contribute to the high variability of exchange rates are examined. Liquidity effects generated by monetary disturbances are shown to have qualitatively similar effects on the world economy in the perfect information case and in the costly information case. However, quantitative differences provide dfferent predictions about the variability of economic variables in the world economy. JEL Classification: F31, F41
[go to paper]

Stagflationary Effect of Government Bond Financing in the Transforming Chinese Economy: A General Equilibrium Analysis
(with Michael K.Y. Fung and Lijing Zhu)
Journal of Development Economics , Vol.61, No.1, p.111-135, 2000.
Abstract: This paper studies how the method of government debt financing affects the macroeconomic performance of the transforming Chinese economy. The investigation is conducted within the context of an endogenous growth model that incorporates the major institutional features of the Chinese economy. Using this framework, we evaluate the effects on the growth rate of output and inflation if the Chinese government relies more on bonds and less on money creation for budget deficit and debt repayment financing. It is shown that although this policy change can reduce the growth rate of the money supply, it can generate a stagflationary effect: reducing the rate of output growth while raising the rate of inflation, if the initial fraction of government deficit and debt repayment financed by bonds is sufficiently small and the tax rate on labor income is sufficiently low.
[go to paper]

The Impact of Credit Control and Interest Rate Regulation on the Transforming Chinese Economy: An Analysis of Long-run Effects
(with Michael K.Y. Fung and Lijing Zhu)
Journal of Comparative Economics , 28(2), 2000, 293-320
Abstract: After identifying the two major institutional features of the Chinese economy, i.e., the coexistence of state-owned enterprises and private firms and tight governmental control over the financial sector, we incorporate these features into an endogenous growth model to investigate the long-run impacts of credit control and interest rate policies on the macroeconomic performance of the transforming Chinese economy. We find that (i) raising the interest rate on government bonds reduces the inflation rate without tempering the output growth rate, (ii) reducing the bank loans available to the state-owned enterprises may lower both the inflation rate and the output growth rate, (iii) increasing the nominal interest rate on bank deposits will exert a stagflationary effect on the economy, i.e., increasing the inflation rate but reducing the output growth rate, and (iv) changing the nominal interest rate on bank loans will have little real effect.
[go to paper]