Populist Policies and Balance-Of-Payment Crises in Emerging Economies

Populist Policies and Balance-of-Payment Crises in Emerging Economies

Alejandro Nakab∗ UC San Diego

March 2018

Abstract

Many emerging economies experience recurrent macroeconomic fluctuations where expansions – characterized by increasing consumption and government spending but decreasing foreign reserves – are followed by balance-of-payment crises. We develop a heterogeneous agent GE small open-economy model calibrated for a semi-industrialized economy where governments tend to avoid currency depreciations due to its distributive effects following a populist approach of macroeconomic management. In the model, the government transfers resources from capitalists to workers through fiscal policy and exchange market interventions, generating short-term expansions and redistribution – even in the presence of negative external shocks– but with balance-of-payment crises in the medium-term, which transfers resources back to capitalists and exporters. More- over, we show that the model’s generated pattern is consistent with 25% of all large depreciation episodes in developing countries in the period between 1950-2016.

∗Email: [email protected]. I am grateful to David Lagakos, Valerie Ramey and Natalia Ramondo for invaluable discussions and advice. I am also grateful to Marc Muendler, Tommaso Porzio and seminar participants at UCSD for helpful comments. 1 Introduction

Since the 1930s, many emerging economies have experienced macroeconomic fluctuations with some common features. Particularly, there were expansions with decreasing foreign reserves associated with populist policies where governments tended to avoid currency depreciations, which ultimately led to a balance of payment (BOP) crisis and a recession (Braun and Joy(1983), Sachs (1990) Dornbusch and Edwards(1990) and Edwards (2003)). After some absent years, there has been a resurgence of populist politicians in many developing economies as is particularly the case in some Latin American countries (Acemoglu, Egorov and Sonin 2013). As Dornbusch and Edwards (1990) defined: “Macroeconomic populism is an approach to economics that emphasizes growth and income distribution and deemphasizes the risks of inflation and deficit finance, external constraints and the reaction of economic agents to aggressive non-market policies.” In this paper, we propose a model to formalize these ideas discussed in this older literature in a modern heterogeneous agents GE model. We study the impact of these populist policies and analyze their distributive effects, focusing on the interaction between re-distributive policies based on exchange market interventions and the external constraint (the economy’s foreign currency availability). Fixed exchange rate regimes required constant central bank interventions to prevent the exchange rate from moving. Although in the last decades many countries tended to “offi- cially” migrate to floating regimes, in practice, central banks systematically intervened in exchange markets (Calvo and Reinhart 2002). In fact, record accumulation of reserves post 2002 has much to do with countries’ willingness to stabilize exchange rates in a world with greater capital mobility (Ilzetzki, Reinhart and Rogoff 2017). In most cases, interventions try to limit appreciations rather than depreciations, following a mercantilist view of de- fending a devalued exchange rate to protect domestic industries (Levy-Yeyati, Sturzenegger and Gluzmann 2013). Nonetheless, the constant loss of foreign reserves before these crises suggest the opposite, meaning exchange market interventions preventing real exchange rate depreciations. These populist cycles in which expansions were followed by BOP crises were vastly documented for South American countries but it was not documented for other countries.1 Therefore, by conducting a case study analysis and using updated data, we first document these patterns for large devaluation episodes for South America in more recent years and for many others African and Asian countries as well. Using yearly data from the World Bank In-

1Among others Braun and Joy(1983), Dornbusch and Edwards(1990) and Edwards (2003) study the macroeconomic ﬂuctuations in Latin American countries.

1 dicators for every country between 1960 and 2015, we first define a BOP crises as a situation where the real exchange rate depreciates more than 30% within a year. We document that in 25% of the 145 large devaluations episodes, countries suffer a decrease in international reserves for at least 2 years (3 years for most cases) before the BOP crises. Then, we restrict the analysis to those devaluation episodes and find that previous years to the BOP crises are associated with (1) large and increasing government spending and consumption which drop sharply at and after the crises and/or (2) negative term of trade shocks several years before the crises. We interpret these dynamics as populist policies, in which policy makers tend to avoid currency devaluations by intervening in the exchange market boosting consumption at the expense of international reserves. We start by constructing a GE small open-economy model with a representative agent (RA) based on Burstein, Neves and Rebelo (2003) and Burstein, Eichenbaum and Rebelo (2007), but extend it by adding foreign reserves and analyzing its behavior when specific fiscal and monetary policies are undertaken. Following the observation that the described pattern is mostly observed in middle-income countries that are net exporters of primary goods and low-skilled intensive goods and net importers of capital goods, we calibrate the model to a semi-industrialized economy with those characteristics. Then, we analyze the features the model must have to generate growth with decreasing foreign reserves. The impulse response functions show that if there is a positive shock to productivity or terms of trade, the economy will experience an increase in output and foreign reserves, generating a positive correlation between these two. We find that we need one of two things to reproduce output growth with decreasing foreign reserves in this model. The first option is a households’ preference shock coming from a decrease in the household discount factor or a decrease in the willingness of households to hold money, which does not seem to be a plausible story behind these recurrent macroeconomic fluctuations. The second is to have an increase in money supply jointly with exchange market interventions to avoid a real exchange rate depreciation. Nonetheless, although the model matches the sign of the correlations from the data, the impulse response functions from these shocks and policies cannot match the timing of the BOP crises. In the model, we find a first expansion and a slow convergence back to the steady state which do not correspond to the expansion followed by a sharp exchange rate depreciation. Given that the RA model fails to match the timing of the BOP crises, we then proceed to include heterogeneous agents. We model an economy with two types of agents: workers with no access to bond markets but who can hold money and capitalists who have access to foreign bond market and who can hold real balances. With this heterogeneous agents model we aim to understand the economic dynamics coming from populist policies, analyzing its income

2 distribution implications at each part of the cycle. We model populist policies as (1) transfers from capitalist to workers driven by increases in taxes and lump-sum transfers between groups and as (2) direct transfers to workers financed by a central bank that issues money to cover a fiscal deficit, both with and without exchange market interventions.2 We find that populist policies provoke changes in mean propensities of consumption and money holding in the aggregate. Particularly, the policies generate a decrease in aggregate savings due to agents having different borrowing constraints and different preferences over real balances.3 Therefore, we provide a deeper explanation for preference changes in the aggregate caused by government policies that redistribute resources. Moreover, when the government intervenes in the exchange market, preventing the exchange rate to devalue while running a fiscal deficit, the model more accurately matches the data pattern, showing one large devaluation episode and recession once the exchange market intervention ends. We then redirect our attention towards populist reaction to external shocks. We show the impulse response function to a negative terms of trade shock followed by different exchange market intervention policies. We show that with no intervention, the terms of trade shock generates a decrease in production with a sharp devaluation and a real wage decrease. Fur- thermore, we find that the more aggressive the intervention in the exchange market is, the lower the real depreciation and the fall in GDP are. In the extreme case, the economy could even experience an expansion with a small real depreciation at the shock if the government spends all its reserves in a short time span, but with a recession once the government stops the intervention. Populist governments can postpone BOP crises to protect workers, even in the presence of negative terms of trade shocks, but for only a short period of time. Finally, as we analyze the income distribution dynamics, we find that we can represent class conflict with a particular measure of real wage (nominal wage over nominal exchange rate, which co-moves with the real exchange rate), which will be a sufficient statistic to know how the real income of each class behaves for each policy chosen. We conclude that populist policies tend to increase the real income of workers and decrease the real income of capitalists and that devaluations increase the real income of capitalist and decrease the real wage of workers. Thus, that cycle alters the wealth and income distributions, increasing the labor share in the presence of populist expansions and decreasing it in BOP crises.

2We sustain the idea that an increase in the size of the public sector, which is one of the most common choices of populist governments, tends to create the same dynamic that an increase in direct transfers to workers financed by taxes or an increase in money supply to cover the fiscal deficit. 3The existence of different consumption bundles of agents across the income distribution was documented a long time ago by Engel (1857, 1895) and also recently by Almas (2012) using household surveys for many countries. To calibrate the model we use an Argentinian survey of household’s consumption and we see that the consumption bundle are in deed different for each decile of the income distribution.

3 Related literature. Due to evidence on the resurgence of macroeconomic populism, this paper studies the role of external restrictions as redistributive policies are implemented. This paper relates to old literature on populist policies, macroeconomic fluctuations, financial instability and contractionary devaluations (Diaz Alejandro (1963), Krugman and Taylor (1978), Braun and Joy(1983), Dornbusch and Edwards(1990) and Edwards (2003) among others). These studies show the dynamics of populist cycles in terms of income redistribution dynamics in expansions and devaluations (mainly empirically) but they do not provide general equilibrium models where all the macroeconomic variables of interest can be jointly analyzed. This paper contributes first by documenting some features of the so-called populist cycle (focusing on exchange rate policies) in emerging economies around the world. More importantly, the main contribution of this paper is to build a modern HA-GE small open-economy model to formally study these policies. In doing so, our contribution relies theoretically on including the role and dynamics of foreign reserves as different policies and exchange market interventions are implemented and studying the distributional effects of these policies. In its focus on exchange market interventions and exchange rate dynamics, this paper relates to the literature on the effects of devaluations on relative prices and the real exchange rate (e.g, Burstein, Eichebaum and Rebelo 2005, 2007). Within this strand of the literature, our paper is closely related to the studies analyzing the distributional effects of large devaluation episodes. For instance, Cravino and Levchenko (2017) show that the impact of devaluations on the cost of living is higher at the bottom compared to top of the income distribution. We focus on workers, firm owners, and exporters and analyze the income distribution dynamics between these groups. Furthermore, our paper relates to the strand of the literature studying exchange market interventions. Levy-Yeyati, Sturzenegger and Gluz- mann (2013) show that in fact many of these interventions tend to act to avoid appreciations although populist policies tend to act in the opposite way. There are no papers that develop the idea of fear of depreciation with the exception of Dutta and Leon (2002) who empirically show that governments tend to avoid nominal exchange rate depreciations, consistently with our notion on populist policies. In its focus on international reserves, our paper is related to the strand of the literature that studies its optimal level and historical dynamics (e.g, Rodrik (2006), Alfaro and Kanczuk (2009), Olivier and Ranciere (2011), Ilzetzki, Reinhart and Rogoff (2017)) although the focus of these studies contrast sharply with ours. These studies focus on interventions to stabilize exchange rates and macroeconomic volatility while we focus on interventions and policies that redistributes resources among groups to benefit workers at the expense of firm owners and exporters. Finally, an important model input is the pattern of specialization and the general struc-

4 ture of the economy, as we think it is a key aspect that actively generates very specific dynamics in the economy. Few prior papers analyze the role and effects of the pattern of specialization when different fiscal and monetary policies are undertaken. Two exceptions are Gavin and Perotti (1997) who show how certain fiscal policies tend to be more disruptive in Latin American economies compared to other industrialized economies and Ilzetzki, Men- doza and Vegh (2013) who show the responses of fiscal shocks in different economies focusing on the differences on exchange rate policy, openness, and external debt levels. Nevertheless, they do not focus on other features as production structure and input-output linkages, which are a key aspect of this paper. The paper is organized as follows: In section 2, we show some regularities for the identified populist BOP crises in the data. In section 3, we construct a representative agent model and analyze what the model must have to match the data correlations and how it fails in successfully describing the BOP crises timing. In section 4, we build an HA-GE model and show how we can match the populist-driven BOP crises described in the presence of expansionary monetary policies and exchange market interventions. In section 5, we show the scenario with negative terms of trade shocks and different exchange market interventions. In section 6, we provide alternative policies on exchange rate regimes; and finally, in section 7, we conclude.

2 Empirical results

We are interested in the link between populist policies and external constraints and, therefore, we focus the analysis on exchange market interventions and policies that end in a BOP crisis. For this purpose, we use yearly data from the World Bank Indicators for all countries between 1960 to 2015. We first define a BOP crises as situations where the real and nominal exchange rates depreciates more than 30% in a year.4 While BOP crises may have different causes, we only focus on those driven by populist exchange market interventions which imply governments must be constantly intervening selling foreign reserves before the large devaluation. We select all BOP crises in which international reserves decreased for at least two consecutive previous years. We find large devaluation episodes all around the world where BOP crises took place after years of falling foreign reserves and we see that this pattern is particularly strong in South America. From 1960 to 2015 there were 145 large depreciation episodes, from which 34 are episodes where countries had falling foreign reserves for more than 2 years previous to the year of the episode (which represents around 25% of

4We restricted the sample to 50%, 30% and 10% and chose 30% to have enough observations but to have depreciation episodes that were also large enough to generate a sizable shock.

5 all devaluation episodes).5 Our restricted sample consists in all emerging economies.6 Note, that macroeconomic dynamics in a developed economies are not usually similar to that of emerging economies; thus, certain policies such as currency depreciations could affect them differently. Moreover, populist policies of income redistribution, as described by Dornbusch and Edwards (1990), are not usually observed in high-income countries which also have floating exchange rate regimes. We show next that virtually all episodes we keep after restricting the sample are devaluations preceded (1) by terms of trade shocks several years before the crisis in which governments try to avoid devaluations intervening in the exchange market as much as their foreign reserves allows them, or (2) by increases in government expenditure, consumption, and real exchange rate appreciations at the expense of a loss in international reserves. Both dynamics are inside our definition of populist policies. Note that even after a term of trade shock which would be exogenous, the choice of intervening in the exchange market for such long periods of time may not be optimal. Figure 2 shows the dynamics on the mean nominal exchange rate, real exchange rate, GDP, foreign reserves, exports and imports, and the dynamics on the components of GDP (C, I, G and CA) from all the large devaluations selected.7 The first feature to point out is the clear contractionary effect from devaluations. As the literature vastly documented currency devaluations tend to be recessionary in developing countries. These sub-figures ∗ show there is a constant real exchange rate appreciation, defined as the change in etPt /Pt, before the large devaluation. At the same time, evidently due to the episodes selection, there is a large decrease in foreign reserves in the year of the large devaluation and in most cases a permanent decrease in the previous 3 years as well. In our definition of populist policies, we focus on exchange market interventions in which governments tend to avoid real depreciations, but note that these interventions have limits as at some point central banks cannot keep on intervening and the economy crashes into an external constraint. We see that after the depreciation international reserves not only stop falling but start increasing, which means the central bank is buying reserves in exchange of domestic currency.

5In the appendix we graph 2 different sets of large devaluations. First, we graph all South American devaluations without any restrictions as they all experience international reserves decreases for more than 2 years (3 years in average) previous to the BOP crisis except for the case of Argentina in 1989, which shows a different pattern. Second, we graph all the rest that includes African, Asian, and a few Central American countries with the restriction of having at least 2 years of falling reserves. Finally, note that our restricted sample does not include the Asian currency crises of the late 1990s which also shows that this currency crisis was not driven by governments intervening in the exchange market, but for other reasons, as sharp and sudden stops in capital inflows. 6From the restricted sample we observe there are no developed economies except Iceland in 1968. 7In the appendix we show every devaluation for South America and the rest of the world with a separate line as well as the means for these two groups.

6 Figure 1: Large Devaluation Episodes

(a) Log Nominal Ex Rate (b) rer change (c) Log GDP

(d) Log Int. Reserves (e) Log Exports (f) Log Imports

(g) Log Gov Expenditure (h) (Gov Exp)/Cons (i) (Gov Exp)/GDP

(j) Consumption/GDP (k) Investment/GDP (l) CA/GDP The graphs show years with a real depreciation of more than 30% jointly with a nominal depreciation of more than 30%. The lines represent the means of all the variables for large devaluations with decreasing reserves in the 2 previous years of the episode.

7 Moreover, in the external front, the dynamics of exports and imports are very clear (there is small variance around the mean) and what we expect to find in any small open economy model. There is a large imports decrease when the devaluation takes place as the recession and depreciation will provoke a lower demand of final goods and a lower demand for imported inputs, as capital goods. After the episode, imports tend to increase once again (as the economy starts growing, demand for imported final goods and foreign inputs increases). In the case of exports, they tend to decrease before the devaluation and they increase after the episode. Furthermore, there is a constant increase in government expenditure up to the year of the devaluation where it decreases substantially. Government expenditure in terms of GDP increases before the devaluation and drops in the same year and after the large devaluation. Consumption (as share of GDP) tends to be higher before than after the devaluation. These general tendencies are consistent with an increasing government spending and a country keeping high levels of consumption that may not be sustainable as the external front tends to deteriorate. Given these patterns, we will focus on exchange market interventions jointly with different government spending policies.

3 Representative Agent Model

We first develop a GE small open-economy model in the spirit of Burstein, Eichenbaum and Rebelo (2007) and Burstein, Neves and Rebelo (2003), and we extend it by adding foreign reserves and analyzing its behavior when specific fiscal and monetary policies are undertaken. The economy is modeled as a partially-industrialized small open economy with comparative advantage in agricultural goods and low-skilled intensive goods. There are 2 sectors in the model: (1) a tradable sector (agricultural goods), and (2) a sector that produces a good that is not internationally traded. The agricultural sector uses labor and land as inputs, and the non traded sector uses an imported input (i.e, high-quality machines) and labor.

Representative agent (RA). For the first specification of the model there is a representative agent in this economy that consumes both final goods and holds money. There is mass one of households [0,1] and the expected utility and budget constraint are defined as:

( ∞ 1+φ ) X Mt L E βt α log(T ) + α log(N ) + α log − t T t N t M P 1 + φ t=0 t

T N ∗ ∗ ∗ m Pt Tt + Pt Nt + Mt + etRt−1Dt−1 + Rt−1Dt−1 = Ωt + Mt−1 + etDt + Dt + ∆t

8 where Tt is the consumption of the tradable, Nt is the consumption of the non-traded, m Mt is money holding, Ωt is income, ∆t is transfers from the government and Lt is labor. ∗ Moreover, Dt−1 is the stock of domestic bonds, Dt−1 is the stock of international bonds, ∗ Rt is the international interest rate, Rt is the domestic interest rate and et is the nominal 8 N T exchange rate deﬁned as local currency per 1 unit of foreign currency. Finally, Pt ,Pt and

Pt are the prices of the non-tradable, the tradable and the consumer price index respectively. Moreover, there are an inﬁnite amount of varieties of the non-traded goods that agents demand. Therefore, Nt is the aggregate amount of the internationally non-traded goods and we use a Dixit-Stiglitz aggregator deﬁned as: σ  σ − 1  Z 1 σ − 1 L Nt =  yit σ di 0

L where yit represents each one of the varieties in the market and σ is the elasticity of substitution between varieties.9

Locally produced good, manufacturing sector. The manufactured goods, being an emerging economy for reasons of low quality or high transportation cost, are not traded in the international markets. There are an inﬁnite number of producers producing a unique variety with a CRS production function of the form:

N N N N γL 1−γL yit = At(Lit ) (Iit)

N where Lit is labor and Iit are imported goods used in ﬁrm i and period t, and At is productivity. The intuition for this production function is that the economy needs high quality capital goods that are not produced domestically, and therefore, the economy needs to import in m∗ order to grow. Moreover, the prices of the inputs are wt for labor and Pt et for the imported good (assuming the law of one price holds), thus, the price of a good in each country will be equal to the price in international markets multiplied by each country exchange rate. In the aggregate we have a CRS production function given by:

N N N N γL 1−γL Yt = At(Lt ) (It)

8 In the case of emerging economies et is the number of units of domestic currency needed to buy 1 USD. 9Note that we use monopolistic competition instead of a simpler perfect competitive market to have positive benefits for the firms and an easy closed form of the price of the non-traded which will be important to analyze the redistributive effects later on.

9 and that the price index given by:

N N m∗ (1−γL ) γL N σ 1 Pt et wt Pt = N N σ − 1 At 1 − γL γL σ where is a constant markup and the rest of the expression is the marginal cost of the σ − 1 good that in this case, as the production function is CRS, is the price in perfect competition with a weighted combination of the input prices.

Tradable sector, agricultural goods. We are modeling an emerging economy that exports commodities and agricultural goods. Thus, two inputs are used (labor and land) to produce the tradable good and the production function is:

T T T T γL T 1−γL Yt = At(Lt ) (At Lat)

T where Lt is labor in sector T in period t and Lat is land that, as it is ﬁxed, is normalized T to 1. In addition, At is country speciﬁc productivity and At is land productivity in sector T ∗ T. As the law of one price holds, the domestic price of the tradable good is: Pt = Pt et.

Income Sources. Households’ have three sources of income. First, there are proﬁts de- KT rived from the tradable sector, denoted by Ωt :

KT T T ∗ Ωt = (1 − γL )Yt Pt et

Note that the production function in this sector is CRS in labor and land, therefore the owners of the land will have proﬁts from the production of the tradable good and that is T going to be exactly the share (1 − γL ) of output. Second, there are proﬁts derived from the KN non traded sector, denoted by Ωt :

N N ∗ (1−γL ) γL KN 1 1 Pt et wt N Ωt = N N Yt σ − 1 At 1 − γL γL

σ Firms charge a constant markup σ−1 over the marginal cost (the price index from the CRS N cobb douglas production function), and Yt is the amount of units sold. Third, there is W income derived from wages, denoted by Ωt :

W T N Ωt = Lt wt + Lt wt

Thus, households’ total income, denoted by Ωt, is the sum of the three sources of income.

10 External sector and aggregation. In this model, domestic agents face an interest rate that is increasing in the country’s net foreign debt:10

∗ ∗ W Dt Rt = Rt exp − d GDPt

From this condition is clear that a higher debt to GDP ratio will generate an increase in the interest rate. Moreover, in this economy the market clearing condition for the non-tradable good implies that domestic consumption must be equal to total production:

N Yt = Nt

On the tradable sector, there are agricultural goods which are exported and non-traded inputs that are imported, and thus, the trade balance (in foreign currency) is deﬁned by:

∗ T m∗ TBt = Pt (Yt − Tt) − Pt It

T where TBt is trade balance, Yt and Tt are production and domestic consumption of the tradable good produced locally, respectively, and It is imported goods used as inputs in the N ∗ m∗ production of the local good Yt . Finally, Pt and Pt are the prices in foreign currency of the agricultural good and the imported good. Moreover, nominal GDP is:

N N N m∗ T T GDPt = Yt Pt − Pt etIt + Pt Yt

Nominal GDP is the total value of production in the tradable sector plus total value of production in the non traded sector net of imported goods used as inputs. The CPI is then:

N N T T Yt Pt N Yt Pt T N T Pt = N N T T Pt + N N T T Pt = γPt + (1 − γ)Pt (Yt Pt + Yt Pt ) (Yt Pt + Yt Pt )

The index is deﬁned as a weighted average of the prices in the tradable and non-tradable sector that are the goods that agents consume. Note that due to the assumption on functional form of the utility function, the shares of consumption of each good relative to total consumption will be constant (γ denotes the share of N that households spend in terms of total consumption goods). Finally, we deﬁne GDP in foreign currency and real GDP as:

N N e GDPt R GDPt GDPt = and GDPt = et Pt 10Following the approach of previous papers as Senhadji (1994), Mendoza and Uribe (2000), Schmitt- Grohe and Uribe (2001), and Schmitt-Grohe and Uribe (2003)

11 where GDP in foreign currency is nominal GDP in domestic currency, divided by the exchange rate and real GDP is nominal GDP divided by the CPI.

Resource Constraint and Balance of Payment. Note that summing all the budget constraints of agents and using the market clearing conditions, the consolidated budget constraint is deﬁned by:

m ∗ ∗ ∗ ∆Mt − ∆t = TBtet + Dt − Rt−1Dt−1 et where the left-hand side represents the excess demand of money (∆Mt is the change in m money demand and ∆t is the change in money supply) and the right-hand side represents net inflow of foreign currency to the economy in domestic currency. A positive trade balance means exports are greater than imports and, therefore, foreign currency is flowing into the economy and a positive second term means the new debt (foreign currency flowing into the economy) is greater than what is being paid of interest and capital for past debt (foreign currency flowing out of the economy). Thus, the behavior of the external sector variables reflects on movements in the monetary base. Therefore, the fundamental BOP identity is:

∗ ∗ ∗ TBt + Dt − Rt−1Dt−1 − ∆RESt = 0

This identity implies the sum of the financial account and the current account must be 0. In our model the current account is represented by the trade balance (the first term in the expression) and the financial account is represented by debt holding (second term) and foreign reserves movements (third term). For the consolidated budget constraint and the BOP identity to jointly hold, the movements in the monetary base must be the equal to the movement of international reserves. This is intuitive, the central bank intervenes in the exchange market selling (or buying) foreign currency with domestic currency at the nominal exchange rate which is the price of that currency. We assume for simplicity that the central bank does not hold foreign bonds which would be an additional tool for interventions in the exchange market without losing international reserves.

Monetary Policy. The central bank can issue money to finance the government’s fiscal deficit and intervene in the exchange market to control the nominal exchange rate by buying m or selling foreign reserves. Thus, the central bank can choose either et or ∆RESt and ∆t (the seigniorage tax). In this economy, if the central bank wants to fix the nominal exchange rate it must supply the amount of money demanded at that price. Moreover, as agents do not hold

12 ∗ ∗ ∗ foreign currency, if there is an inﬂow of foreign currency (TBt + Dt − Rt−1Dt−1 > 0) the central bank will accumulate reserves as agents go to the exchange market to sell that foreign currency to accumulate more real balances or consume domestically. From the consolidated budget constraint and the BOP identity it is easy to see that

m ∆Mt − ∆t = et∆RESt.

m If the central bank does not intervene in the exchange market then ∆Mt = ∆t which means that households must hold the exact level of money the central bank issues, and therefore an increase in money supply will be reflected in higher prices in the presence of no frictions – meaning money will be neutral. Moreover, if there is a disparity between the additional money demanded by households and the change in the level of the monetary base due to exogenous shocks or policies, the central bank can intervene in the exchange market by selling (buying) foreign reserves. If the central bank wants to fix the exchange rate or decrease its volatility, the level of foreign reserves become a key factor to conduct policy. Finally, the real exchange rate is defined as:

∗ ∗ Pt Pt RER = et = et N T Pt γPt + (1 − γ)Pt

Note that both domestic prices depend on the exchange rate but only the non-traded price also depends on wages. If international prices do not move, the real exchange rate will depend on the nominal exchange rate and on nominal wages. In this sense, it can be shown that an

increase (decrease) in wt/et generates a real exchange rate appreciation (depreciation). Note that the ﬁrst order condition from the agricultural producers’ problem implies

wt T ∗ T T γL −1 = Pt AtγL (Lt ) et

Additionally, from the non-traded good producers’ problem, the ﬁrst order conditions imply

N wt m∗ γL It = Pt N et (1 − γL ) Lt

Thus, a real exchange rate appreciation driven by a demand-side shock (some preference changes or government policies) shrinks the tradable sector and increase the relative weight of imported goods relative to labor in the non-tradable good production. Therefore, these types of shocks that do not alter international prices or productivity generate a negative impact in the trade balance.

13 3.1 Calibration

We calibrate the model to a small semi-industrialized economy, as this is the most common type of economy that shows the pattern described. In particular, we calibrate the model to match speciﬁc moments of the Argentine economy. We use the “Encuesta de gasto de los hogares 2012-2013” (survey of household’s consumption expenditure) to calibrate the propensities of consumption from the utility function for each type of good. Appendix Table 5 shows the shares of consumption for manufacturing, services and agricultural goods and food for each decile of the income distribution. Using these data, we construct a measure of weighted consumption to calibrate the preferences of the representative agent. To capture the described economic structure, we assume manufacturing goods and services are non- traded and that agricultural goods and foods (main exports) are traded goods which means that the consumption of tradable goods is roughly 30% and consumption of the non-traded goods is 70%. Moreover, we calibrate the propensity to hold real balances to match the monetary base in the economy as a share of GDP. For the supply side, we ﬁrst assume the Cobb Douglas parameter on labor in the trad- T able sector is γL = 0.4. Gollin (2002) shows, for the naive worker compensation calculation, agricultural goods in comparable countries to Argentina is around 0.311, but we also need to include food production in the tradable sector for Argentina, which has a higher worker T compensation; thus, increasing the value of γL . Therefore, to match the exact income dis- N tribution and income sources, we have 2 extra parameters that are σ and γL that determine the compensation for workers and capitalist in the N sector. To match this data we assume T that σ = 6, which generates a 20% markup on the non traded domestic good, and γL = 0.9, which means that 90% of the expenditure in inputs is labor, and 10% is imported inputs. Table 1 summarizes the parametrization and SS values for nominal variables.

3.2 RA model: Results

The central bank has 4 possible policies to follow: (1) fixed exchange rate regime with a passive policy (only changing the monetary base according to changes in demand); (2) a fixed exchange rate regime with an active monetary policy (increasing money supply to finance a fiscal deficit); (3) a floating exchange rate regime with an active monetary policy and exchange market interventions; or (4) a floating exchange rate regime with an active

11This naive calculation refers to the fact that other types of income that should count as part of worker compensation as the income of self-employed workers are not included. This could be a real problem for some poor economies where self-employed rural workers produce a big percentage of the agricultural production, but nonetheless, this is not the case of middle-income countries such as Argentina where agricultural production is mostly concentrated in few big ﬁrms.

14 Table 1: Parameter Values

Value Comments Source/mom. match β 0.99 Households discount factor - αN 0.7 Preference parameter on N ENGHo αT 0.3 Preference parameter on S ENGHo αM 0.0008 Preference parameter on M match M/NGDP T γL 0.4 Worker compensation in T sector Gollin (2002) N γL 0.8 Share to W without considering markup match 0.66 in NT. σ 6 Elasticity of substitution between varieties I-O and I.D. mom. φ 1.6 Frish elasticity Garcia-cicco et al (2010) et 1 Exchange rate steady state value Normalization ∗ Pt 1 Tradable international price steady state value Normalization m∗ Pt 1 Imported good international price steady state value Normalization At 1 Productivity steady state value Normalization Where ENGHo is the Argentinian national survey of household’s consumption (2012); M/NGDP is M1 over nominal GDP over the decade, which is approximately 10%; I-O is input-output matrix for Argentina (2002); and I.D. mom. is income distribution moments.

monetary policy, but without exchange market interventions. Although for completeness is important to mention all of them, the fourth policy will not have any real impact as there are no frictions to make money non-neutral.12

Fixed exchange rate regime and passive policy. First, we start by analyzing what the economy needs to produce an increase in GDP and consumption with a decrease in m foreign reserves if the government ﬁxed the exchange rate with a passive policy (∆t = 0). If the central bank has a passive policy, the only oﬃcial intervention includes selling or buying foreign reserves in the exchange market to ensure the nominal exchange rate does not change. Therefore, external shocks, productivity shocks or demand shocks must drive the business cycle. So far, in this simple simulation, we start by analyzing shocks with the following stochastic processes: ss ss log(xt/x ) = ρx log(xt−1/x ) + x

∗ m∗ where x is an external shock (Pt ,Pt ), a productivity shock (At), or a preference shock

(βt, αm). The impulse response functions show that if there is a positive shock to productivity or terms of trade, the economy will have growth with increasing foreign reserves (this shocks will generate a positive correlation between GDP and foreign reserves). Therefore, the only way of explaining the observed dynamics, without a direct active policy from the government, is to have some kind of preference shock. To observe the same correlation as in the empirical

12Note that in this model, as there is no friction with a floating regime, an increase in money supply generates inflation and there are no effects in the real economy (shown later on). Therefore, a floating regime must be used with an active policy on the exchange market to control the exchange rate, and at the same time, boost consumption (as a decrease in reserves for example will allow an increase in imports, or an increase in ∗ ∗ ∗ consumption of the tradable good, without higher debt. Recall that: TBt + Dt − Rt−1Dt−1 −∆RESt = 0.

15 evidence, we need agents demanding less money relative to goods. Based on the RA model, there are 2 possible shocks that could provoke an increase in consumption (and GDP) with a decrease in money holding. The ﬁrst option is an exogenous preference shock that makes real balances less desired by households (with, for example,

a decrease in αM , Appendix Figure 14), and the second option is to have a shock that decreases the discount factor β that will increase consumption and decrease money holding and savings (Appendix Figure 13 ). Nevertheless, in the data there are recurrent BOP crises in places like South America, and it is not likely to have recurrent cycles due to changes in the discount factor or in the propensity to hold real balances. To get more interesting explanations we need to go one step further adding other government policies in the model that provide endogenous reactions of agents with similar dynamics in the aggregate.

Fixed exchange rate regime and active policy. We must note that if the central bank fixed the exchange rate, any policy producing inflation will also produce a real exchange rate appreciation as the price of the foreign currency will not change. This fixed nominal exchange rate will then break the neutrality of money as an increase in money supply will produce inflation only in wages and a change in relative prices. An increase in money supply (for example, when the government finances fiscal deficits with transfers from the central bank) generates a rise in households’ income, causing an increase in money demand. Nevertheless, the direct transfer of money will be used to increase real balances and also to consume more goods. As households enlarge the consumption of both goods, this provokes an expansion in the non-traded sector boosting wages and rising prices, which ultimately lead to a higher increase in money demand. Nevertheless, as Figure 12 shows, even though money demand rises, that rise is lower than the increase in money supply that happens before the exchange market intervention. This causes a decrease in

foreign reserves as the central bank must intervene in the exchange market for et not to change (sterilized intervention). In a ﬁxed exchange rate model, the policy function implies that the monetary policy will maintain the exchange rate constant at some exogenous level and, therefore, the money supplied will be determined by the demand of money at the ﬁxed exchange rate. In Appendix Figure 12, we show there is a second force driving the decrease in reserves that is the RER appreciation generating tradables (locally produced commodities and imported goods) to be relatively cheaper compared to other inputs (as wages increase). Thus, this policy with reserves decumulation will boost consumption, generating a decrease in the TB and debt holding (this second one due to the fact that households want to smooth consumption, saving part of the temporary transfer from the government).

16 Moreover, in a fixed exchange rate regime, aggregate exports, foreign reserves and the access to foreign bond markets determines how much the economy can import to increase production and consumption. In the medium-term if the economy does not increase exports, the amount of goods that the economy can acquire will be limited (external restriction). Real appreciations with economic growth only have as counterpart a decrease in international reserves, and if the economy runs out of foreign currency to be able to buy those imported goods, a BOP crisis may occur. These results can be thought in the context of the trilemma of international finance. Note that the government cannot fully control the monetary base with a fixed exchange rate regime and free capital mobility. Therefore, an increase in the fiscal deficit with an increase in money supply automatically means a decrease in foreign reserves. By the definition of Dornbusch and Edwards (1990), this is a populist policy as it emphasizes growth and deemphasizes the risk of inflation, deficit finance or external constraints. In this sense, the government is boosting consumption but this policy, that generates short-term growth, will eventually crash with the external restriction as the economy will run out of reserves, as we see next once we endogenize the nominal exchange rate.

Floating exchange rate. We assume there is an intermediate regime where the government let the exchange rate float but it attempts to influence the exchange rate by buying or selling foreign currency in exchange for domestic currency. Therefore, the authority will M choose the amount of money to issue (∆t ) and the amount of foreign currency to sell/buy in the exchange market (∆RESt). Figure 2 shows a temporary increase in money supply (3 years) of 10% of steady state GDP including exchange market interventions (orange line) and without interventions (blue line). Note that as this model does not have any friction, an increase in the monetary base will just produce inflation but not real effects on the economy. Moreover, governments have the incentive of intervening in the exchange market to avoid the nominal exchange rate appreciation and have an impact on agents’ consumption. This RER appreciation generate an increase in the production of the non-traded (as consumption increases) and a decrease in the production of the tradable. This will provoke a BOP crisis with a devaluation once the government stops selling reserves (once they run out). At that point we can observe that there is a real devaluation as the exchange rate increases more than prices, and also a decrease in consumption and non-traded production occurs. In the model, we find a first expansion and a slow convergence to the steady state with medium-sized devaluations just before the first expansion and at the end of the exchange market intervention. Moreover, in the first devaluation the dynamics on foreign reserves are

17 M Figure 2: Shock to ∆t with and without intervention in exchange market

IRFs from shock to money supply with and without exchange market intervention. The blue line represents the IRFs of the representative agent model with passive policy and the orange line represents the IRFs with exchange market interventions. The graphs of non traded good, tradeable good production and real exchange rate represents the log deviations from steady state and the international reserves graph shows levels where .25 represents 20% of steady-state GDP. not the ones observed in the data. Therefore, this model cannot exactly match the timing in every step of the cycle, and although it matches the correlations between the real exchange rate and output it does not match the correlation between the movement of international reserves (between period 2 and 12) and output.

Results on the RA model. According to the results, with a passive policy and a fixed exchange rate, we know there must be a preference shock to replicate the dynamics observed in the data. What the model needs is aggregate propensities of consumption of goods to increase relative to the propensity to hold money. Nevertheless, it is not likely to observe recurrent cycles due to changes in the discount factor or the willingness to hold real balances. Thus, from those first results, there is a clear necessity of including an active fiscal or

18 monetary policy as a first step. Moreover, once we include an active policy with and without market interventions, we can match the correlations we observe in the data (in terms of real exchange rate movements and growth) but not the exact timing of the BOP crisis. Furthermore, in these populist policies there are redistributive consequences and, although in this simple RA model we cannot analyze the income distribution dynamics, we can note that the income source from the agricultural sector will decrease while the income source of the workers and the non- traded good capitalists will increase with the real exchange rate appreciation. In order to analyze this last redistributive dynamic, it is useful to decompose the representative agent into different type of households with their own preferences and income sources to analyze the dynamics in the income distribution that provokes changes in the mean propensities of consumption and money holding. Moreover, the income and substitution effect of the workers once the transfers are redistributed will play an important role in the economy’s response. The explanation developed in this paper is based on the existence of heterogeneous agents and the dynamics of the income distribution causing changes in the aggregate propensities of consumption and money holding when populist policies are undertaken. With the existence of heterogeneous agents (workers and capitalist/exporters) we will match not only the correlations but also the timing of the BOP crisis.

4 Heterogeneous Agents and Populist Policies

The dynamics of the income redistribution among agents with potentially different preferences will alter the aggregate propensities of consumption and savings. Nonetheless, note that if the distribution of income did not change after the shock a representative agent approach would have the ability of explaining what we observe in the data. In order to provoke changes in the income distribution, we add a government that transfers resources among agents with different fiscal policies and a central bank that intervenes in the exchange market.

Heterogeneous Agents. Agents are divided into 2 groups: capitalist (industrial and agricultural owners of firms) and workers. Therefore, there is mass one of households [0,1], and θi represents the mass of individuals of type i and therefore θw +θK = 1 where the supra index w refers to workers and K refers to capitalist. These groups have different sources of income and their preferences may also differ in some key aspects, which may generate different consumption baskets across the income distribution.

19 Workers. The expected utility and budget constraint are given by:

( ∞ ) X M w L1+φ E βt αwlog(T w) + αw log(N w) + αw log t − t T t N t M P 1 + φ t=0 t

T w N w w w w w Pt Tt + Pt Nt + Mt = Mt−1 + Ωt + ∆t

w In addition to the previously deﬁned variables, ∆t is the net transfer the group receives w from the government and Ωt is income coming from the wage earned by working in both sectors. Note that workers are credit constrained and, thus, they cannot hold external or domestic bonds. Capitalists. The expected utility and budget constraint are given by:

( ∞ ) X M K E βt αK log(T K ) + αK log(N K ) + αK log t T t N t M P t=0 t

T K N K K K∗ K∗ K K K K∗ K K Pt Tt + Pt Nt + Mt + etRt−1Dt−1 + Rt−1Dt−1 = Ωt + Mt−1 + etDt + Dt − ∆t

K K K where ∆t is a transfer from the government (positive ∆t means lump sum tax), and Ωt is the capitalists’ income (profits from the tradable sector and the non-tradable sector). Note that capitalists are not credit constrained and therefore they can save in domestic or external bonds. Finally, these agents are the owners of the factors of production but will not supply labor.13 Note that the functional form of the utility functions is the same among groups. Nev- i ertheless, the taste parameters represented by αj for each good j and individual i could be different among groups. Moreover, keeping aggregate income constant, redistribution of income among groups would change demand and real balances holding in the aggregate. This difference in income sources, marginal propensities of consumption and access to credit produces changes in the aggregate propensities of consumption and it could also produce a decrease in money holding with an increase in GDP.

Supply side. The production functions in the tradable and non-tradable sector are as before: T T T T γL T 1−γL Yt = At(Lt ) (At Lat)

N N N N γL (1−γL ) Yt = At(Lt ) (It) 13With this assumption we can calibrate in a way of including their labor income inside proﬁts increasing markup or the labor share in the tradable production function.

20 and the prices, as in the previous RA speciﬁcation, are:

T ∗ Pt = Pt et

m m∗ Pt = Pt et

N N m∗ (1−γL ) γL N σ 1 Pt et wt Pt = N N σ − 1 At 1 − γL γL

Income Sources. In the same way as before, the income sources do not change, but the K distribution of that income is diﬀerent. Capitalists have an income denoted by Ωt where K KN KT W Ωt = Ωt + Ωt , and Ωt is workers’ income. Income sources are deﬁned as before:

KT T T ∗ T ∗ T Ωt = (1 − γL )Yt Pt et = Yt Pt et − Lt wt

N N ∗ (1−γL ) γL KN 1 1 Pt et wt N Ωt = N N Yt σ − 1 At 1 − γL γL W T N Ωt = Lt wt + Lt wt Note here that future extensions can be done by separating the capitalist sector by income source, which will end up having more types of agents and a richer analysis of winners and losers from each one of the ﬁscal and monetary policies studied in this paper.

Fiscal Policy, Government. The government redistributes resources via lump-sum transfers and lump-sum taxes and can run a ﬁscal deﬁcit. Thus, the government’s budget constraint is: K m w ∆t + ∆t = ∆t

K w where ∆t is lump sum tax for capitalist and ∆t is the transfer to workers. The government m can also run a fiscal deficit (∆t ) financed by the central bank. We assume the government does not increase public debt. As it is observed all over the developing world, a common way of generating short-term growth (and redistribution) when the private sector does not generate new jobs is to increase the public sector’s size. Specifically, increasing the amount of workers in the public sector to boost wages (at the expense of increasing the cost of inputs in the private sector) is another policy that populist governments execute. An increase in wages in the public sector must be financed by taxes or by the central bank, and therefore, all types of populist experiences will be modeled as direct transfers to workers to simplify the theoretical analysis. Thus, an increase in the public sector’s size can be interpreted in this model as net transfer between

21 groups or net transfers from the central bank to workers in the case that the monetary authority ﬁnances ﬁscal spending.

External sector and aggregation. The foreign interest rate for capitalists as before is deﬁned as: K∗ i∗ W etDt K Rt = Rt exp K − d Ωt /θK which means that the interest rate will depend on the stock of debt relative to income this group has. In this economy the market clearing conditions for the non-traded goods and money imply that: N w K Yt = Nt + Nt

w K Mt = Mt + Mt In the tradeable sector we can deﬁne the trade balance as:

∗ T w K m∗ TBt = Pt [Yt − Tt − Tt ] − Pt It

and, the deﬁnitions of nominal GDP, real GDP, GDP in foreign currency and CPI in this economy are the same as before.

Consolidated budget constraint and BOP identity. Summing all the budget constraints (agents and government) we get the following consolidated budget constraint:

m ∗ ∗ ∗ ∆Mt − ∆t = etTBt + et Dt − Rt−1Dt−1

and the balance of payment identity is given by:

∗ ∗ ∗ TBt + Dt − Rt−1Dt−1 − ∆RESt = 0 |{z} | {z } Current Account Financial Account

As before, the monetary policy is driven by money supply and exchange market interventions.

Driving forces on income distribution dynamics. As Dornbusch and Edwards (1990) state, the recommended policy (from the populist point of view) is to “actively use macroeconomic policy to redistribute income, typically by large real-wage increases that are not to be passed on into higher prices. However, even if inflationary pressures do develop, the populist policymaker rejects devaluation because of a conviction that it reduces living standards and because it will have further inflationary impact without positively affecting the external

22 sector.” We start from this statement and further develop the income distribution dynamic. One interesting feature of the model is that we can get a sufficient statistic to study income redistribution dynamics using the ratio between nominal wage and nominal exchange rate. We can show (see the mathematical appendix) that real income of different types of agents are functions of wt . Therefore, using an alternative definition of real wage we get one et variable that represents the class conflict in terms of income redistribution. Moreover, the representative agent model showed the real exchange rate is a function of that ratio, and thus, income redistribution across sectors (in the absence of productivity increases or external shocks) will depend solely on the real exchange rate.14 A devaluation produces redistribution in favor of capitalists and a decrease in workers’ standard of living but, the model rejects the idea of devaluations not positively affecting the external sector as we explain next.

4.1 Calibration

To calibrate the different groups preference parameters, we need additional assumptions. We assume capitalist are the top 10% of the income distribution and workers are the bottom 90%. It can be shown that most of the income of the top 5%-10% is capital income. There are two ways of redistributing and achieving the results that we observed in the data. The first option is to calibrate the model in a way that both types have the same preferences but different budget constraints (i.e, workers are credit constrained). In this case, agents will save less overall and this would mean a decrease in money demand in the aggregate. Moreover, as workers are consuming almost all their income, redistributing from capitalists to workers would also generate an increase in consumption of the T and NT. This is probably part of the story behind the data but not all there is. A second way to get the results is to calibrate preferences to get different marginal propensities of consumption of each one of the goods for each type of agent. In this case, we would need workers to have a higher propensity of consumption of the non-traded goods W K (αN > αN ). We can see that if this is the case, we would observe the same pattern in the model and data. Nevertheless, workers have lower income per capita than capitalists and it is well known that as people become richer, the share of consumption in services increases and the consumption of other tradable goods, for example, food, decreases.15 By calibrating the model with data on consumption shares by income, we notice that if T is mainly agricultural goods and food, the share of consumption for workers would be much higher than the one

14If there are multiple shocks affecting the economy at the same time, for example TFP shocks or terms of trade shocks, each sector’s real income will not solely depend on the real exchange rate, but nevertheless a real exchange rate appreciation will push worker’s (capitalist’s) real income to increase (decrease). 15It makes sense to have different preference parameters for each group, which would be similar to having non-homothetic preferences and agents with different levels of wealth.

23 Table 2: Parameter Values

Value Comments Source β 0.99 Households discount factor - w αN 0.7 Preference parameter on N for w ENGHo w αT 0.3 Preference parameter on S for w ENGHo w αM 0.0005 Preference parameter on M for w match M/NGDP k αN 0.7 Preference parameter on N for k ENGHo k αT 0.3 Preference parameter on S for k ENGHo k αM 0.0015 Propensity to consume M for k match M/NGDP T γL 0.4 Worker’s Compensation in T sector I-O and I.D. mom. N γL 0.9 Share to W without considering markup I-O and I.D. mom. σ 6 Elasticity of substitution varieties I-O and I.D. mom. φ 1.6 Frish elasticity Garcia-cicco et al (2010) θw 0.9 Share of workers in population I.D. mom. θK 0.1 Share of capitalists in population I.D. mom. et 1 Exchange rate steady state value Normalization ∗ Pt 1 Tradable international price steady state value Normalization m∗ Pt 1 Imported good international price steady state value Normalization At 1 Productivity steady state value Normalization

Note: ENGHo is the Argentine national survey of household’s consumption (2012); M/NGDP is M1 over nominal GDP over the decade, which is approximately 10%; I-O is input-output matrix for Argentina (2002); and I.D. mom. is income distribution moments. for capitalists. Therefore, we would need to include a third sector (service) to calibrate the model in a way of observing a growing manufacturing sector with a decrease in reserves. That is why we include specifications with other sectors and inputs in the appendix to study the distribution of wealth in richer setups. In this two-sector model we assume both groups have the same relative preference for T and NT but different relative preference over goods W K W K and real balances. Thus, we assume that αN = αN = 0.7 and αT = αT = 0.3, and i that αM may differ. We simulate two cases. First we simulate the model with homothetic W K preferences which means αM = αM , to capture the dynamics of the model with differences in borrowing constraints and the role of income and labor supply. Second, we calibrate the parameters defining real balances holding to match the monetary base in the economy as a share of GDP and the money holding of workers and capitalists. Finally, we keep the same parameter values describing the supply side as in the RA model.

4.2 Results on Heterogeneous Agents and Populism

Floating exchange rate, no exchange market intervention, and no foreign bonds. We start by analyzing a case with no foreign bonds, and therefore, capitalists are able to save only in domestic bonds. In this case, the trade balance is equal to the movement in reserves and, if the central bank does not intervene in the exchange market, the trade balance must

24 be equal to 0 in equilibrium at all times. Figure 3 represents a temporary increase in money supply (in the ﬁrst 3 years) of about 10% of GDP with those resources going to the workers (or capitalist depending on the simulation) and no exchange market interventions (constant amount of reserves).

Figure 3: Shock to ∆M without intervention in exchange market

Note: IRFs from shock to money supply without exchange market intervention. The blue line represents the IRF of the representative agent model, which is the same as the IRF of an heterogeneous agent model with inelastic labor supply. The rest are IRFs of different specifications of the heterogeneous agent model. HP stands for homothetic preferences and NHO stands for non-homothetic preferences (workers’ and capitalists’ preferences differ in taste for real balances). Moreover, the purple and green lines represent the case in which all the money supply goes to capitalists and the orange and red represent the case in which all transfers go to workers.

Figure 3 shows what happens once we include redistribution aspects of government spending. In this case, once we have different groups, and without exchange market interventions the real economy is affected. In this case, as transfers go to workers (orange and red IRFs), the real exchange rate appreciates and the production of the tradable goods decreases. Nonetheless, there is a decrease in the production of the non-tradable good as well. We see the opposite effect on output when the same amount of transfers go to capitalist (purple and

25 green IRFs). This shock produces a real exchange rate depreciation, expanding the tradable sector, and increasing labor supply due to a high negative income effect for workers. Even having the same preferences, the non-neutrality of money result is driven by the income and substitution effect of workers, which drives the real exchange rate to drop or increase. 16 Therefore, an important takeaway is that as these two groups have different income sources, and only workers supply labor, money will be neutral only if there is an inelastic labor supply.

Figure 4: Shock to ∆M with intervention in exchange market

IRFs from shock to money supply with exchange market interventions. The graphs of non traded good, tradeable good production and real exchange rate represents the log deviations from steady state and the international reserves graph is in levels where .25 represents 20% of steady state GDP.

Floating exchange rate, exchange market interventions and no foreign bonds. We now proceed to include exchange market interventions which is the key point of the populist policies described. In Figure 4, we plot the same monetary expansion with exchange market interventions and, in this case, there is a production expansion in the non-tradable sector and a contraction in the tradable sector. Moreover, we observe that this real appreciation ends up in an endogenous, large devaluation once the authority stops selling foreign reserves (as they cannot aﬀord to keep losing this asset), which generates a recession in the non tradable sector and an expansion in the tradable sector. The overall pattern and timing

16simulating the same model with an inelastic supply of labor an increase in money supply is neutral

26 are not similar in the RA and HA model. In the RA model the non-traded good production never drops below the steady state level, and in the HA model, the expansion is lower and the drop in the devaluation makes the economy temporary worse than the initial steady state. Nevertheless, in this simulation we do not include foreign bonds in the HA model and, we will see how these results change once we do incorporate them.

Floating exchange rate, exchange market intervention and foreign bonds Once we include foreign debt for capitalists (see Figure 5), the dynamics after the monetary expansion with exchange market interventions are very similar to the ones in the HA model without foreign debt, but with a large expansion once the policy starts. Capitalists borrow when the policy starts boosting consumption, making the real exchange rate appreciate even more and generating a greater loss in terms of tradable production and exports.

Figure 5: Shock to ∆M with intervention in exchange market

Note: IRFs from shock to money supply with exchange market interventions. The graphs of non traded good, tradeable good production, and real exchange rate represents the log deviations from steady state and the international reserves graph shows levels where .25 represents 20% of steady-state GDP.

The important conclusion from this exercise is that the access to external debt will only exacerbate the magnitudes but in terms of the qualitative dynamics, we will observe an expansion up to the end of the exchange market intervention when a large devaluation and a recession take place. Note that with the HA model, we can even better replicate the

27 dynamics observed in the data with expansions up to the large devaluation accompanied by a recession as reserves stop falling. Finally, note that we show the results with only a decrease in reserves to provide cleaner intuitions on the mechanisms driving results, but we can analyze the case where foreign reserves increase after the crisis. In Appendix Figure 20, we show the same simulations but with an increase in reserves after the crisis. This simulation tends to show the case where agents expect policy makers to increase the stock of reserves after the BOP crisis. This is what we observe in the data, where after large devaluation episodes, foreign reserves increase in average. This simulation shows that the patterns are the same as the ones previously described with the only diﬀerence being that the appreciation is a bit lower at the beginning (and the devaluation is larger once reserves stop falling) and GDP growth is smaller (larger) in the appreciation (depreciation) part of the cycle.

5 Terms of Trade and Exchange Market Interventions

There are two main reasons for these populist BOP crises to occur in our data sample. The first was direct populist policies as described by Dornbusch and Edwards (1990), which basically corresponds to policies generating inflation and expanding government expenditure to generate growth and redistribution in the short-term without considering external constraints. We discussed those government policies in detail. The other corresponds to populist reactions to external shocks. Populist experiences may occur when in good states (high terms of trade) government expenditure and consumption increases due to the higher level of income, but then, when external conditions change (terms of trade decreases), the government does not adjust spending and artificially prevents consumption to decrease. In a floating exchange rate regime a decrease in the price of the exported goods would generate a devaluation and a fall in production, nevertheless populist governments may want to react, intervening in the exchange market for the domestic currency to not devalue sharply and to avoid both a decrease in GDP and a real wage decrease in the short-term. In this section, we simulate a negative shock to terms of trade, in particular a 5% decrease in the price of the exported good that lasts for 3 years (12 quarters) and different monetary policies. Figure 6 plots 4 different policies. First, we plot the economic reaction of a non- intervention policy as well as 3 scenarios where the government uses all the disposable reserves in different time horizons (1, 2, or 3 years). The results show that with no intervention, the terms of trade shock generates a decrease in the non-tradable production and a sharp devaluation which boosts tradable production as real wages decrease. Furthermore, the faster the government spends its international reserves, the lower the real depreciation and

28 Figure 6: Terms of Trade Shock and Exchange Market Intervention

the fall in GDP are. In the extreme case, if the government spends all its reserves in one year, the economy could even experience an expansion with a small real depreciation at the shock. Note that when the government spends all the foreign reserves in one year or two, there is a devaluation with a recession once the government runs out of reserves, therefore generating a BOP crisis much later than the year with shock in the terms of trade. After three years, the terms of trade return to the levels before the shock and the economy returns to the same steady state. Finally, it is interesting to note that some degree of intervention may be optimal. A slow intervention (in which reserves fall for 3 years, see purple line) may decrease the sharp recession at the shock and generate a much smoother transition to the point in which the bad shock to the terms reverts after 3 years. Nevertheless, although the economy’s dynamics are smoother, this intervention would not prevent the recession at the shock, and therefore, present-biased governments may still want to intervene more aggressively at the beginning. In fact, we empirically observe that there are expansions before the sharp balance of payment crisis which corresponds to the case where reserves fall excessively fast.

29 6 Government Incentives and Alternative Policies

After describing the cycle and policies that generate the dynamics observed in the data we can proceed to analyze which incentives governments have to execute these type of policies. For this we focus on the distributional eﬀects these policies generate. Moreover, we describe alternative policies to analyze the cycle from a diﬀerent perspective.

What are the incentives for exchange market interventions? We simulate a transfer from capitalists to workers without an increase in money supply. In this case, note that the relationship in the exchange market is:

m ∆Mt − ∆t = et∆RESt

m Note that if the central bank does not increase the money supply (∆t = 0) or intervene in the exchange market, the drop in demand for money of one group must equal the increase in the demand of the other group. Appendix Figure 21 shows the reason why governments are incentivized to intervene in the exchange market. A transfer from capitalists to workers generates an increase in workers’ consumption and a decrease in capitalists’ consumption. In the case with non-homothetic preferences there is a decrease in the demand for money in the aggregate. If the central bank ﬁxes the exchange rate, then that decrease in the demand for money will generate a decrease in foreign reserves and create a real appreciation. Moreover, this real appreciation generates a decrease in the production of the tradable good, although GDP tends to increase in the aggregate. Moreover, it is clear that these policies might be optimal if governments want to increase workers purchasing power and consumption or simply to redistribute resources to have a more equal society.

Government targeting nominal exchange rate and exogenous devaluation. In the previous exercises, the nominal exchange rate was endogenous and we observed how endogenous devaluations occurred once the government ran out of reserves. Moreover, in this last section we show what would happen if, instead of managing the level of foreign reserves, the government chooses to target the level of the nominal exchange rate. In this case, we simulate a transfer of resources from capitalists to workers and a devaluation after 2 years that agents anticipate. We see the same patterns as the ones described in previous sections where this policy generates a BOP crisis with a high RER devaluation and a boom before the crisis and a recession during. Moreover, the simulations provide the economy’s response to the exchange market inter-

30 Figure 7: Expected shock to et of 30% in period 8 (one year from present)

ventions and increases in money supply. We see how these populist policies of transfers and forced real exchange rate appreciations have an end in a BOP crisis. The model replicates the pattern of the data. When this type of policy is implemented, the economy ends up in a large real devaluation and a recession when the central bank stops intervening in the exchange market even in this fully rational expectation model.

7 Conclusion

As Dornbusch and Edwards (1990) nicely defined, “Macroeconomic populism is an approach to economics that emphasizes growth and income distribution and deemphasizes the risks of inflation and deficit finance, external constraints and the reaction of economic agents to aggressive non-market policies.” In this paper, we propose a model to formalize these ideas discussed in the old literature in a modern HA-GE small open-economy model. This paper contributes to the macroeconomic literature by developing a model to study the role of populist policies of income redistribution and the role of the external restriction in developing countries, deeply analyzing the behavior of foreign reserves and exchange market intervention policies. We first document that in 25% of all 145 large devaluations episodes, countries suffer a decrease of international reserves for at least 2 years (3 years for most cases) before the BOP crisis and that the years before the crisis are associated with (1) increasing government expenditure and consumption, and/or (2) negative term of trade shocks. We interpret these dynamics as populist policies, in which policy-makers tend to avoid currency devaluations

31 by intervening in the exchange market boosting consumption at the expense of international reserves. With our model we study the dynamics of the economy and the income distribution in terms of capitalists and workers. A nice feature of the model is that we can represent class conflict with a particular measure of real wage (nominal wage over nominal exchange rate), which is a sufficient statistic in this setup to characterize how each sector’s real income behaves with different exchange market interventions and government expenditure policies. We show that populist policies tend to increase workers’ real income at the expense of capitalists’ real income but that large devaluation episodes revert this effect in the medium- term. This study is relevant for policy analysis. The model shows how populist policies cannot generate sustainable growth and highlights how governments can redistribute resources and generate growth in a sustainable way. For economies that need to import capital goods in order to grow, the only sustainable plan of development requires one of three things: an increase in exports, an increase in productivity, or a manufacturing sector capable of producing high quality capital goods to replace the imported goods. All of these policies will generate long-term growth and stability without a BOP crisis. Therefore, in this particular setup, any redistribution driven by a policy-induced real exchange rate appreciation and no change in productivity or the structure of the economy will lead to a decrease in international reserves and a crisis.

32 Bibliography

• Levy-Yeyati, Eduardo, Federico Sturzenegger, and Pablo Alfredo Gluzmann. ”Fear of appreciation.” Journal of Development Economics 101 (2013): 233-247.

• Levy-Yeyati, E., and Sturzenegger, F. (2005). Classifying exchange rate regimes: Deeds vs. words. European economic review, 49(6), 1603-1635.

• Dutta, Jayasri and Hyginus, Leon. Dread of depreciation: Measuring real exchange rate interventions. No. 2-63. International Monetary Fund, 2002.

• Dornbusch, Rudiger, and Sebastian Edwards. ”Macroeconomic populism.” Journal of Development Economics 32.2 (1990): 247-277.

• Burstein, A., Eichenbaum, M., and Rebelo, S. (2005). Large devaluations and the real exchange rate. Journal of political Economy, 113(4), 742-784.

• Burstein, A., Eichenbaum, M., and Rebelo, S. (2007). Modeling exchange rate passthrough after large devaluations. Journal of Monetary Economics, 54(2), 346-368.

• Cravino, Javier, and Andrei A. Levchenko. The distributional consequences of large devaluations. No. w23409. National Bureau of Economic Research, 2017.

• Azzimonti, Marina, Eva De Francisco, and Per Krusell. ”Production subsidies and redistribution.” Journal of Economic Theory 142.1 (2008): 73-99.

• Jeanne, Olivier, and Romain Ranciere. ”The optimal level of international reserves for emerging market countries: a new formula and some applications.” The Economic Journal 121.555 (2011): 905-930.

• Frenkel, Jacob A., and Boyan Jovanovic. ”Optimal international reserves: a stochastic framework.” The Economic Journal 91.362 (1981): 507-514.

• Ben-Bassat, Avraham, and Daniel Gottlieb. ”Optimal international reserves and sovereign risk.” Journal of international Economics 33.3-4 (1992): 345-362.

• Alfaro, Laura, and Fabio Kanczuk. ”Optimal reserve management and sovereign debt.” Journal of International Economics 77.1 (2009): 23-36.

• Rodrik, Dani. ”The social cost of foreign exchange reserves.” International Economic Journal 20.3 (2006): 253-266.

33 • Ilzetzki, Ethan, Carmen M. Reinhart, and Kenneth S. Rogoﬀ. Exchange Arrangements Entering the 21st Century: Which Anchor Will Hold?. No. w23134. National Bureau of Economic Research, 2017.

• Ilzetzki, E., Mendoza, E. G., and Vegh, C. A. (2013). How big (small?) are ﬁscal multipliers?. Journal of monetary economics, 60(2), 239-254.

• Allen, F., and D. Gale. (2001). Financial Contagion. Journal of Political Econ- omy,108(1): 133

• Cespedes, L. F., Chang, R., y Velasco, A. (2003). IS-LM-BP in the pampas. IMF Economic Review, 50(1), 143-156.

• Braun, O., y Joy, L. (1968). A Model of Economic StagnationA Case Study of the Argentine Economy. The Economic Journal, 868-887.

• Diaz Alejandro, C. F. (1963). A Note on the Impact of Devaluation and the Redis- tributive Eﬀect. The Journal of Political Economy, 577-580.

• Freixas, X., B.M. Parigi, and J.-C. Rochet. (2000). Systemic Risk, Interbank Re- lations,and Liquidity Provision by the Central Bank. Journal of Money, Credit and Banking, 32: 611638.

• Furﬁne, C. (2003). Interbank Exposures: Quantifying the Risk of Contagion. Journal of Money, Credit and Banking, 35(1): 111129.

• Heymann, D., Kaufman, M., y Sanguinetti, P. (2001). Learning about trends: Spend- ing and credit ﬂuctuations in open economies. In Monetary Theory as a Basis for Monetary Policy (pp. 173-214).

• Krugman, P., y Taylor, L. (1978). Contractionary eﬀects of devaluation. Journal of International Economics, 8(3), 445-456.

• Lizondo, J. S., y Montiel, P. (1989). Contractionary Devaluation in Developing Coun- tries: An Analytical Overview. IMF Staﬀ Papers, 182- 227.

• Sanchez, M. (2008). The link between interest rates and exchange rates: do contractionary depreciations make a diﬀerence?. International Economic Journal, 22(1), 43-61.

• Stiglitz, Joseph E., and Mauro Gallegati. (2011) Heterogeneous interacting agent models for understanding monetary economies. Eastern Economic Journal 37.1 6-12.

34 • Stiglitz, J., and B. Greenwald. (2003). Towards A New Paradigm in Monetary Eco- nomics. Cambridge: Cambridge University Press.

• Sachs, J. (1990). Social conﬂict and populist policies in Latin America. In Labour relations and economic performance (pp. 137-169). Palgrave Macmillan, London.

8 Appendix: Empirical Evidence

35 Figure 8: South American Large Devaluation Episodes

(a) Log Nominal Exchange Rate (b) Real Exchange rate change

(e) Log Exports (f) Log Imports The graphs show years with a real depreciation of more than 30% jointly with a nominal depreciation of more than 30%. Moreover, all South American devaluations with that characteristic were included: Argentina (1963, 1982, 1989, 2002), Brazil (1983, 1999), Chile (1974, 1975), Colombia 2015, Paraguay (1984, 1987, 1989), Uruguay (1983, 2002), Venezuela (1984, 1987,36 1989, 2002, 2011). We drop Argentina 1975 which has a diﬀerent pattern in terms of foreign reserves. All oranges lines represents each one of the episodes while the black line represents the mean of the episodes. Figure 9: South American Large Devaluation Episodes

(a) Log Government Spending (b) Gov Spending/Consumption

(e) Investment/GDP (f) CA/GDP The graphs show years with a real depreciation of more than 30% jointly with a nominal depreciation of more than 30%. Moreover, all South American devaluations with that characteristic were included: Argentina (1963, 1982, 1989, 2002), Brazil (1983, 1999), Chile (1974, 1975), Colombia 2015, Paraguay (1984, 1987, 1989), Uruguay (1983, 2002), Venezuela (1984, 1987,37 1989, 2002, 2011). We drop Argentina 1975 which has a diﬀerent pattern in terms of foreign reserves. All oranges lines represents each one of the episodes while the black line represents the mean of the episodes. Figure 10: Rest of the World Large Devaluation Episodes

(a) Log Nominal Exchange Rate (b) Real Exchange rate change

(e) Log Exports (f) Log Imports The graphs show years with a real depreciation of more than 30% jointly with a nominal depreciation of more than 30%. We include all countries with a decrease in foreign reserves of at least 2 years before the devaluation: Cameroon 1994, Congo, Dem. Rep. 2001, Dominican Republic 2003, Iceland 1968, Iran, Islamic Rep. 1993, Iran, Islamic Rep. 2002, Iraq 2003, Lao PDR38 1998, Mauritania 1993, Niger 1994, Nigeria 1999, South Africa 1985, Togo 1994, Trinidad and Tobago 1986, Turkey 2001, Uganda 1984. Equatorial Guinea 1994 follows the same pattern but was not included for scale purposes. For the rer change Iraq 2003 and Iran 1993 were dropped for scale purposes Figure 11: Rest of the World Large Devaluation Episodes

(a) Log Government Spending (b) Gov Spending/Consumption

(e) Investment/GDP (f) CA/GDP The graphs show years with a real depreciation of more than 30% jointly with a nominal depreciation of more than 30%. We include all countries with a decrease in foreign reserves of at least 2 years before the devaluation: Cameroon 1994, Congo, Dem. Rep. 2001, Dominican Republic 2003, Iceland 1968, Iran, Islamic Rep. 1993, Iran, Islamic Rep. 2002, Iraq 2003, Lao PDR39 1998, Mauritania 1993, Niger 1994, Nigeria 1999, South Africa 1985, Togo 1994, Trinidad and Tobago 1986, Turkey 2001, Uganda 1984. Equatorial Guinea 1994 follows the same pattern but was not included for scale purposes. Table 3: Countries by changes in Terms of trade adjustment

Decrease 2 years before devaluation Decrease same year of devaluation No Decrease Argentina (1963) Argenina (1982) Paraguay (1989) Argentina (1989) Argentina (2002) Venezuela (1984) Brazil (1983) Chile (1974) Uruguay (1993) Brazil (1999) South Africa (1985) Uganda (1984) Chile (1975) Belarus (2015) Ukraine (2014) Colombia (2015) Serbia (2002) Paraguay (1984) Paraguay (1987) Venezuela (1987) Venezuela (1989) Venezuela (2002) Venezuela (2011) Uruguay (2002) Iran (1993) Iran (2002) Iraq (2003) Dom. Rep. (2003) Iceland (1968) Turkey (2001) Togo (1994) Cameroon (1994) Russian Federation (2015) Serbia (1998)

40 Table 4: Countries by changes in Net barter terms of trade index

Decrease 2 Years Before Decrease in Same Year No decrease Argentina (1982) South Africa (1985) Mauritania (1993) Argentina (1989) Paraguay(1989) Argentina (2002) Zambia(1986) Azerbaijan (2016) Belarus (2015) Brazil (1983) Brazil (1999) Cameroon (1994) Colombia (2015) DRC (2001)Ukraine(2014) Dominican Republic (2003) Equatorial G. (1994) Iran (2002) Iraq (2003) Mozambique (2016) Niger (1994) Nigeria (1999) Paraguay (1984) Paraguay (1987) Russian Federation (2015) Sao Tome and Principe (1997) Togo (1994) Trin. and Tob. (1986) Turkey (2001) Ukraine (2014) Uruguay (1983) Uruguay (2002) Venezuela (1984) Venezuela (1987) Venezuela (1989) Venezuela (2002) Venezuela (2011)

41 9 Appendix 1: Representative Agent Model

9.1 System of equations.

The competitive equilibrium is a ... where the following equations hold at every t: Demand side:

αT αN T = N (1) TtPt NtPt

αM αN αN = N − β N (2) Mt NtPt Nt+1Pt+1

αN ∗ et+1 αN N βRt = N (3) Nt+1Pt+1 et NtPt

∗ et+1 Rt = Rt (4) et

W T N Ωt = Lt wt + Lt wt (5)

N N ∗ (1−γL ) γL KN 1 1 Pt et wt N Ωt = N N Yt (6) σ − 1 At 1 − γL γL

KT T T ∗ Ωt = (1 − γL )Yt Pt et (7)

φ αT L T = (8) TtPt wt

T N ∗ ∗ KN KT w ∗ m Pt Tt + Pt Nt + Mt + etRt−1Dt−1 + Rt−1Dt−1 = (Ωt + Ωt + Ωt ) + Mt−1 + etDt + Dt + ∆t (9)

42 Supply side

T T T T γL T 1−γL Yt = At(Lt ) (At Lat) (10)

T T T T T (γL −1) T 1−γL Pt γL At(Lt ) (At Lat) = Wt (11)

T ∗ Pt = Pt et (12)

N N N N γL γI Yt = At(Lt ) (It) (13)

N N n N N (γL −1) (1−γL ) Pt γL At(Lt ) (It) = Wt (14)

N N n N N N N γL −γI m Pt (1 − γL )Pt γL At(Lt ) (It) = Pt (15)

m m∗ M Pt = Pt et(1 + τt ) (16) σ P N = P n (17) t σ − 1 t

Aggregate variables and external sector:

m (Mt − Mt−1) − ∆t = et∆RESt (18)

KT ∗ ∗ W etDt Rt = Rt exp e − d (19) GDPt

N Yt = Nt (20)

Dt = 0 (21)

∗ T m∗ N TBt = Pt et(Yt − Tt) − Pt etIt (22)

N N N m∗ T T GDPt = Yt Pt − Pt etIt + Pt Yt (23)

N N T Yt Pt N TtPt T CPIt = N N T Pt + N N T Pt (24) (Yt Pt + TtPt ) (Yt Pt + TtPt )

N e GDPt GDPt = (25) et

N R GDPt GDPt = (26) CPIt

43 Transitory shocks:

ss ss log(At/A ) = ρA log(At−1/A ) + A (27)

ss ss log(βt/β ) = ρβ log(βt−1/β ) + β (28)

ss ss log(αM t/αM ) = ραM log(αM t−1/αM ) + αM (29)

ss ss log(et/e ) = ρe log(et−1/e ) + e (30)

m m ∆t = ρ∆m ∆t−1 + ∆m (31)

Variables(34):

w KT KN K∗ T T T N N n m N N Tt; Nt; Mt;Ωt ;Ωt ;Ωt ; Dt ; Dt; Rt; Yt ; Pt ; Lt ; Yt ; Pt ; Pt ; Pt ; wt; I ; Lt

K∗ N e R M m Rt ; TBt; ∆RESt; CPIt; GDPt ; GDPt ; GDPt ; At; βt; αt ; et; ∆t ;

Shocks:

K m M I e; αM ; β; A; ∆ ; ∆ ; τ ; τ .

44 9.2 Representative agent model: Shocks to β and αm

M Figure 12: Shock to ∆t

Figure 13: Shock to β

45 Figure 14: Shock to αM

46 10 Appendix 2: Heterogeneous Agent Model

10.1 Appendix 3: System of equations. Heterogeneous Agent Model

The competitive equilibrium is a ... where the following equations hold at every t: Demand Side:

w w αT αN w T = w N (1) Tt Pt Nt Pt w w w αM αN αN w = w N − β w N (2) Mt Nt Pt Nt+1Pt+1

φ αT L T = (3) TtPt wt

W T N Ωt = Lt wt + Lt wt (4)

T w N w w w w w Pt Tt + Pt Nt + Mt = Ωt + Mt−1 + ∆t (5)

K K αT αN K T = K N (6) Tt Pt Nt Pt

K K K αM αN αN KN = K N − β K N (7) Mt Nt Pt Nt+1Pt+1

K K αN K∗ et+1 αN K N βRt = K N (8) Nt+1Pt+1 et Nt Pt

K∗ et+1 Rt = Rt (9) et

N N ∗ (1−γL ) γL KN 1 1 Pt et wt N Ωt = N N Yt (10) σ − 1 At 1 − γL γL

KT T T ∗ T ∗ T Ωt = (1 − γL )Yt Pt et = Yt Pt et − Lt wt (11)

T K N K K ∗ K∗ K K K K∗ K K Pt Tt + Pt Nt + Mt + etRt−1Dt−1 + Rt−1Dt−1 = Ωt + Mt−1 + etDt + Dt + ∆t (12)

47 Supply side:

T T T T γL T 1−γL Yt = At(Lt ) (At Lat) (13)

T T T T T (γL −1) T 1−γL Pt γL At(Lt ) (At Lat) = Wt (14)

T ∗ Pt = Pt et (15)

N N N N γL γI Yt = At(Lt ) (It) (16)

N N n N N (γL −1) (1−γL ) Pt γL At(Lt ) (It) = Wt (17)

N N n N N N γL −γI m Pt (1 − γL )γL At(Lt ) (It) = Pt (18)

m m∗ M Pt = Pt et(1 + τt ) (19) σ P N = P n (20) t σ − 1 t

Public sector:

I W K M m∗ N K m w τt (Ωt + Ωt ) + τt Pt etIt + ∆t + ∆t = ∆t (21)

48 Aggregate variables and external sector:

K w K w Mt + Mt − Mt−1 − Mt−1 = et∆RESt (22)

KT ∗ K∗ W etDt KT Rt = Rt exp KT − d (23) Ωt /θKT

N K w Yt = Nt + Nt (24)

Dt = 0 (25)

∗ T K w m∗ N TBt = Pt et[Yt − (Tt + Tt )] − Pt etIt (26)

N N N m∗ T T GDPt = Yt Pt − Pt etIt + Pt Yt (27)

N N T T Yt Pt N Yt Pt T CPIt = N N T T Pt + N N T T Pt (28) (Yt Pt + Yt Pt ) (Yt Pt + Yt Pt )

N e GDPt GDPt = (29) et

N R GDPt GDPt = (30) CPIt

Possible transitory shocks:

ss ss log(At/A ) = ρA log(At−1/A ) + A (31)

ss ss log(et/e ) = ρe log(et−1/e ) + e (32)

m m ∆t = ρe∆t−1 + ∆m (33)

K K ∆t = ρ∆K ∆t−1 + ∆K (34)

Variables(36):

w K w K w K w KN KT K∗ w T t ; Tt ; Nt ; Nt ; Mt ; Mt ;Ωt ;Ωt ;Ωt ; Dt ; Dt; Rt; ∆t ;

T T T N N n m N N K∗ Yt ; Pt ; Lt ; Yt ; Pt ; Pt ; Pt ; wt; I ; Lt ; Rt ; TBt; ∆RESt;

e R I M m K CPIt; GDPt; GDPt ; GDPt ; At; et; τt ; τt ; ∆t ; ∆t

K m M I Shocks: e; αM ; β; A; ∆ ; ∆ ; τ ; τ .

49 10.2 Government choosing exchange rate level and transfers

We assume that the capitalist are the top 10% of the income distribution and the workers are the bottom 90%. This is because we can show that most of the income of the top 5%-10% is capital income. Note that the choice of 10% is due to the availability of data in order to calibrate the marginal propensities of consumption. In following sections we use a diﬀerent calibration with the capitalist being the top 20% of the income distribution. Moreover, for the calibration we use data for Argentina which is a country with a very strong dynamic in terms of the populist policies and macroeconomic instability.

Figure 15: Transitory expected shock to et of 30% in period 4 (one year from present)

50 Figure 16: Shock to ∆kt - Redistribution with lump sum transfers (same marginal propensities) 51 Figure 17: Shock to ∆M - Increase in money supply lump sum transfers to workers

52 Figure 18: Expected shock to et of 30% in period 8 (one year from present)

K Figure 19: transitory shock to ∆t of 20% of Kinc for 2 years and permanent shock to et of 30% in 2 years

53 K Figure 20: transitory shock to ∆t for 3 years with the same intervention before the crisis and diﬀerent intervention after crisis (Case with foreign debt)

54 Figure 21: Shock to ∆kt with ﬁxed and ﬂoating regimes

IRFs from shock to lump sum transfers from capitalist to workers with ﬂoating exchange rate and no intervention and with in a ﬁxed exchange rate regime. The graphs of non traded good, tradeable good production and real exchange rate represents the log deviations from steady state and the international reserves graph is in levels where .25 represents 20% of steady state GDP.

55 11 Appendix 3: System of equations. Heterogeneous Agent 3 Sector Model

The competitive equilibrium is a ... where the equations from Appendix 2 hold, adding the following 6 equations:

w w αS αN w S = w N St Pt Nt Pt

K K αS αN K S = K N St Pt Nt Pt

KS 1 wt N Ωt = St σ − 1 At

N K w St = St + St

N S St = AtLt

S σ wt Pt = σ − 1 At and changing:

N T S θw = Lt + Lt + Lt

W T N S Ωt = Lt wt + Lt wt + Lt wt

T w N w S w w w w w Pt Tt + Pt Nt + Pt St + Mt = Ωt + Mt−1 + ∆t

T K N K K ∗ K∗ K KS KN KT I K Pt Tt + Pt Nt + Mt + etRt−1Dt−1 + Rt−1Dt−1 = (Ωt + Ωt + Ωt )(1 − τt ) + Mt−1 + K∗ K K etDt + Dt + ∆t

N N N m∗ S S T T GDPt = Yt Pt − Pt etIt + Yt Pt + Pt Yt

N N N T T T S S S Yt Pt ∗ Pt Yt Pt ∗ Pt Yt Pt ∗ Pt CPIt = N N T T S S + N N T T S S + N N T T S S (Yt Pt + Yt Pt + Yt Pt ) (Yt Pt + Yt Pt + Yt Pt ) (Yt Pt + Yt Pt + Yt Pt )

56 Variables(36+6):

w K w K w K w KN KT K∗ w T t ; Tt ; Nt ; Nt ; Mt ; Mt ;Ωt ;Ωt ;Ωt ; Dt ; Dt; Rt; ∆t ;

T T T N N n m N N K∗ Yt ; Pt ; Lt ; Yt ; Pt ; Pt ; Pt ; wt; I ; Lt ; Rt ; TBt; ∆RESt;

e R I M m K CPIt; GDPt; GDPt ; GDPt ; At; et; τt ; τt ; ∆t ; ∆t

w K KS S S St; St ; St ;Ωt ; Pt ; Lt

Shocks:

K m M I e; αM ; β; A; ∆ ; ∆ ; τ ; τ .

Parameters:

12 Appendix 4: Calibrations

Table 5: Share in Consumption Bundle T-N

1 2 3 4 5 6 7 8 9 10 T 57.6 51.5 46.3 44.7 41.4 37.3 34.0 30.5 25.7 19.4 N 42.4 48.5 53.7 55.3 58.6 62.7 66.0 69.5 74.3 80.6 Ac.I% 1.3 4.0 8.0 12.0 19.0 26.0 36.0 48.0 65.0 100.0 I% 1.3 2.7 4.0 4.0 7.0 7.0 10.0 12.0 17.0 35.0

Table 6: Consumption Bundle: Representative Agent Model

TN Av(1-10) 38.8 61.2 W.Av(1-10) 29.5 70.5

57 Table 7: Consumption Bundle Heterogeneous Agent Model (20%-80%)

TN Av(1-8) 42.9 57.1 Av(9-10) 22.5 77.5 W.Av(1-8) 38.2 33.8 W.Av(9-10) 21.4 78.6

Table 8: Consumption Bundle Heterogeneous Agent Model (10%-90%)

TN Av(1-9) 41.0 59.0 Av(10) 19.4 80.6 W.Av(1-9) 34.9 65.1 W.Av(10) 19.4 80.6

Table 9: Share in Consumption Bundle T-N-S

1 2 3 4 5 6 7 8 9 10 T 57.6 51.5 46.3 44.7 41.4 37.3 34.0 30.5 25.7 19.4 N 15.5 16.7 18.3 19.0 19.4 19.7 20.1 19.9 19.1 21.2 S 26.9 31.8 35.4 36.3 39.3 43.0 45.9 49.6 55.2 59.4 Ac.I% 1.3 4.0 8.0 12.0 19.0 26.0 36.0 48.0 65.0 100.0 I% 1.3 2.7 4.0 4.0 7.0 7.0 10.0 12.0 17.0 35.0

Table 10: Consumption Basket Heterogeneous Agent 3 Sector Model (20%-80%)

TNS Av(1-8) 42.9 18.6 38.5 Av(9-10) 22.5 20.2 57.3 W.Av(1-8) 38.2 19.3 42.5 W.Av(9-10) 21.4 20.5 58.0

Table 11: Consumption Basket Heterogeneous Agent 3 Sector Model (10%-90%)

TNS Av(1-9) 41.0 18.6 40.4 Av(10) 19.4 21.2 59.4 W.Av(1-9) 34.9 19.3 45.8 W.Av(10) 19.4 21.2 59.4

58 13 Appendix 5: Theoretical proofs

13.1 Driving forces on income dynamics: proofs

Sufficient statistic. In a fixed exchange rate regime with zero foreign inflation and constant productivity, if the nominal wage increase, the real wage will increase in terms of both goods. Note that the tradable good will have a fixed price, and thus the real wage will increase trivially. In terms of N note that the price will increase less than the increase in PN.

The changes in real wage in terms of N is given by:

" N #−1 N γL w σ 1 1 − γ N 1−γN t N L m∗ (1−γL ) L N = Wt = N N (Pt et) Atwt Pt σ − 1 1 − γL γL

σt−1 (1−γN ) (1−γN ) 1−γN W N σ − 1 A P m∗ L e L w L =⇒ t = t−1 t t−1 t−1 t N σt m∗ Wt−1 At−1 Pt et wt−1 σt − 1 The real wage in terms of T is given by:

wt T ∗ −1 T = Wt = (Pt et) wt Pt

T ∗ Wt Pt−1 et−1 wt =⇒ T = ∗ Wt−1 Pt et wt−1 Finally, we can rewrite the real wage as a function of nominal wage and exchange rate. This will be very useful to analyze later on the distributive eﬀects. If there are no shocks to productivity, foreign prices we get:

N !1−γL W N wt t = et W N wt−1 t−1 et−1 ! W T wt t = et W T wt−1 t−1 et−1 We can rewrite real income of the agricultural capitalist as a function of wage and nominal exchange rate. Note that: T T T T γL T 1−γL Yt = At(Lt ) (At Lat)

59 T T Lt wt Yt = T T γL Pt

1 T 1−γT T P L T T T 1−γL t Lt = γL At(At Lat) wt using the ﬁrst and third equation we have:

γT γT L 1− L T 1−γT T Pt L T T 1−γ T T 1−γL Yt = z L γL where z = At(At Lat) wt we know that: T T T ∗ T ∗ T Ωt = (1 − γL )Yt Pt et = Yt Pt et − Lt wt We can rewrite the real income of the land owners in tradable goods as:

γT γT L KT 1− L 1−γT Ωt T 1−γT T ∗ et L L T = (1 − γL )z γL Pt Pt wt

T T γL T T γL − 1−2γ 1−2γ wt ! 1−γT KT T L T L ∗ 1−γT L Ωt /Pt At At Pt L et =⇒ KT T = T ∗ wt−1 Ω /P At−1 A P t−1 t−1 t−1 t−1 et−1 Doing the same procedure for the real income in terms of the non traded we get:

γT γT L KT 1− L 1−γT T Ωt T 1−γT T ∗ et L Pt L N = (1 − γL )z γL Pt N Pt wt Pt

KT T From this expression we can see that we will have the same dynamics as Ωt /Pt but interacting with the dynamic of the relative prices. This latter dynamic can be rewritten as:

N N m∗ (1−γL ) γL σ 1 Pt−1et−1 wt−1 P T /P N P ∗e σ − 1 A 1 − γN γN t t = t t t−1 L L T N (1−γN ) γN ∗ P /P m∗ L L P et−1 t−1 t−1 σ 1 Pt et wt t−1 N N σ − 1 At 1 − γL γL

σt−1 N (1−γN ) w !−γL P T /P N P ∗ A σ − 1 P m∗ L t t t = t t t−1 t−1 et T N ∗ σt m∗ wt−1 P /P P At−1 P t−1 t−1 t−1 t et−1 σt − 1

60 T σt−1 N γL T T 1 N −γ − 2−2γ 1−2γ (1−γ ) wt ! L 1−γT KT N L T L ∗ 1−γT m∗ L L Ω /P σ − 1 A A P L P =⇒ t t = t−1 t t t t−1 et KT N σt T ∗ m∗ wt−1 Ω /P At−1 A P P t−1 t−1 t−1 t−1 t et−1 σt − 1

Finally, we can rewrite the real income of the T capitalist as a function of nominal wage and exchange rate. If there are no shocks to productivity, foreign prices we get:

γT − L KT T wt ! 1−γT Ω /P L t t = et ΩKT /P T wt−1 t−1 t−1 et−1

γT −γN − L KT N wt ! L 1−γT Ω /P L t t = et ΩKT /P N wt−1 t−1 t−1 et−1 we can rewrite the real income of the NT capitalist as a function of nominal wage and exchange rate. Note that N N N N γL 1−γL Yt = At(Lt ) (It)

1 1 N (1−γN ) N γN N Pt N L Pt N L N where: Lt = γL At It and It = m∗ (1 − γL )At Lt wt Pt et Note that:

1 ΩKN = P N Y N t σ t t

KN N N Ωt /Pt σt−1 Yt =⇒ KN N = N Ωt−1 /Pt−1 σt Yt−1

KN T T N −1 N Ωt /Pt σt−1 Pt /Pt Yt =⇒ KN T = T N N Ωt−1 /Pt−1 σt Pt−1/Pt−1 Yt−1

σt−1 N (1−γN ) w !−γL P T /P N P ∗ A σ − 1 P m∗ L t Where, as before: t t = t t t−1 t−1 et T N ∗ σt m∗ wt−1 P /P P At−1 P t−1 t−1 t−1 t et−1 σt − 1 N Yt wt Lastly we need to study the behavior of N depending on the movements of . We Yt−1 et can show that in a real devaluation with foreign bonds and money in the model the eﬀect is recessive. Nonetheless, this result depends on the income eﬀect as when the exchange rate is devalued there is a loss in real balances and an increase in real foreign debt. Therefore,

61 the correlation between wt and Y N in both shocks (populist transfers and devaluations) will et t be positive in this set up.

Therefore, assuming zero foreign inﬂation, constant terms of trade, non productivity increase and constant markups, the real income of agents depends only on the dynamic of ( wt ). et With variable markups, we would add a third variable for which real income of agents would change favoring industrial capitalist and hurting workers and land owners when this increases.