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The Impact of Financial Crisis and Policy Response in Croatia

Analyzing the impact of the financial crisis on Croatia and exploring possible monetary policy responses using a small open economy DSGE model. Simulation exercises are conducted to assess the effects of shocks on various economic variables. Comparison with actual developments and conclusions are drawn.

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The Impact of Financial Crisis and Policy Response in Croatia

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  1. The Impact of Financial Crisis and PolicyResponse in Croatia Nikola Bokan, Lovorka Grgurić, Ivo Krznar, Maroje Lang 15th Dubrovnik Economic Conference June 2009

  2. Outline • Motivation • Model structure • Simulation exercise • Comparison with the actual developments • Conclusion

  3. 1 Motivation Aim : • Understand the impact of the current financial crisis on Croatia and possible monetary policy response Method : • Unprecedented shocks prevents us to use standard statistics • Testing a newly built model in a challenging situation

  4. 2. Model – introductory remarks • Small open economy DSGE model • Built with a purpose to analyze different possible shocks facing Croatian economy • Contains large number of possible shocks • Calibrated and not estimated • Different from standard IT model due to different monetary policy regime • Stable exchange rate, heavy use of regulations (RR) • Monetary policy works through banking sector • Financial eurisation • Interest in financial variables (credit, debt)

  5. Model structure

  6. Monetary policy in the model • Stable exchange rate (random walk) • Reserve requirement as monetary policy instrument • Discretionary monetary policy

  7. High regulatory cost(defined as “immobilized” assets / total liabilities)

  8. 3. Simulation exercise • Current financial crisis simulated as an external shock to Croatian economy • Increase in price of foreign borrowings (3 pp) • Drop in exports (10 %) • Impulse responses

  9. Foreign interest rate shock • increase in foreign interest rates: • cost of foreign borrowing increases for both banks and firms • domestic interest rates increase even more due to RR • real sector: • increase in debt/service & production cost • decrease in demand (consumption) => decrease in production & imports • financial sector: • decrease in credit demand (HH and firms) • decrease in foreign borrowing

  10. Export demand shock • decrease in exports lowers domestic production and household income • real sector: • decrease in demand (consumption) => decrease in production & imports • financial sector: • decrease in credit demand (HH and firms) • decrease in foreign borrowing

  11. Monetary policy response • Limited room for maneuver • Exchange rate depreciation would increase debt service cost and bad loans due to eurization (not fully modeled) • Monetary authorities can decrease regulatory cost (RR) • Simulation of 10 pp decrease in RR

  12. Reserve requirement reduction • Decrease in regulatory cost • Decrease in domestic interest rates • Some increase in real economic activitydue to lower interest rate (consumption, production, imports) • Release of previously immobilized assets • Significant decrease in foreign borrowing • Banks can't lend all released assets domestically

  13. Combined effect of three shocks • Monetary easing through RR only marginally reduces negative impact of the crisis on real sector • Net exports improve (imports decrease more than exports) • Interest rate increases significantly • Credit activity decreases • Significant reduction in foreign borrowing

  14. 4. Comparison with the actual developments • Early dana showing initial impact of the crisis are available

  15. Model predicted:Slowdown in real activity

  16. Improvement in trade balance

  17. Decrease in credit activity

  18. However:Domestic interest rates increased moderately

  19. Reasons for moderate increase in domestic interest rates • Impact of shock might be exaggerated in simulation • Decreased faster than assumed by the model • Foreign borrowing by banks/firms actually cheaper/postponed • Reduction in RR contributed to less interest rate increase • Popular pressures against interest rates increase and already high bank profits • evidence of credit-rationing instead

  20. Foreign borrowing continued (although somewhat slower than before)

  21. Reason why foreign borrowing slowed only marginally GOVERNMENT BORROWING • Banks lent to the government as fiscal revenues dropped

  22. 5. Conclusion • The results to a large extent match the actual data showing the early impact of the crisis • model is a useful policy analysis tool • With stable exchange rate regime, decreasing the regulatory burden can only marginally reduce the negative impact of the current crisis on real economy

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