In many countries, not just LDCs, financial markets are underdeveloped and access to foreign capital is restricted. Frequently, the main source of finance is bank loans, and only banks have access to foreign capital. In standard theoretical models of exchange rate determination, investment is a key element in the transmission of monetary shocks. These models are designed, however, for countries with well developed capital markets, and they ignore institutional features of investment.
In Discussion Paper No. 355, Merih Uctum and Research Fellow Michael Wickens analyse the effects of monetary shocks on exchange rate determination in the presence of underdeveloped capital markets. They construct a model to illuminate the central role played by banks in providing finance for domestic firms and in international capital transactions. For clarity, domestic bank deposits and foreign securities are assumed perfect substitutes, and the only domestic assets held by foreign residents are bank deposits. Banks act as profit-maximizing monopolists in setting the loan rate, while the deposit rate is determined by their need to compete in the international capital market.
Firms are assumed to finance their investment entirely from bank loans and retained earnings. Their demand for bank loans is derived from a multi-period framework in which firms' net worth is maximized. Their optimization decision involves both Tobin's q, the real shadow price of capital, and a new factor, the shadow price of debt, which depends on expectations of future interest rates. Loans are used to invest in physical capital to produce domestic output, so aggregate supply is endogenous.
The model's long-run properties resemble those of the familiar Mundell-Fleming model. A domestic monetary shock has no real effects in the long run, and an aggregate demand shock has an instantaneous effect on the real exchange rate. In the short run, the effects of domestic and foreign monetary shocks are very different. Uctum and Wickens construct a rational expectations model, calibrated to coefficients widely used in the literature, in order to perform dynamic simulations of domestic and foreign monetary shocks. The results show that some resort to debt finance for investment seems to help stabilize the economy in the face of domestic monetary shocks: short-run fluctuations in investment are reduced because fluctuations in interest rates are discounted through time. Similarly, exchange rate volatility is inversely proportional to the leverage ratio of firms, and reducing the reserve requirements of banks also reduces exchange rate volatility.

In contrast, Uctum and Wickens's simulations reveal, financing investment in this way makes the economy more vulnerable to a foreign monetary shock. A rise in world interest rates has real long-run effects, reducing investment, the capital stock and output. This is different from standard models, in which output is exogenous. In the short run, however, economic activity incr- eases because the exchange rate depreciation dominates the effect of reduced investment.

Exchange Rate Determination with Bank-Financed Investment Merih Uctum and M R Wickens

Discussion Paper No. 355, November 1989 (IM)