Bank of Lithuania
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All results 219
No 49
2018-04-27

The behavioral economics of currency unions: Economic integration and monetary policy

  • Abstract

    Currency unions are often modeled as homogeneous economies, although they are fundamentally different. The expectations that impact macroeconomic behavior in any given country are not the expectations of variables at the currency-union level but at the country level. We model these expectations with a behavioral reinforcement learning model. In our model, economic integration is of particular importance in determining whether economic behavior in a currency union is stable. Monetary policy alone is insufficient to guarantee stable economic behavior, as the central bank cannot conduct different monetary policies in different countries. These results are easily overlooked when modeling expectations as rational.

    JEL Codes: E03, F45, E52, D84.

    The views expressed are those of the author(s) and do not necessarily represent those of the Bank of Lithuania.

No 21
2018-04-06

Overview of Lithuania’s banking sector sustainability in the post-crisis environment

  • Abstract

    In the aftermath of the financial crisis, Lithuania‘s banking sector faced structural changes related to higher concentration, decreased interconnectedness and lower risk appetite. At the same time banks were able to maintain strong profitability levels measured by the EU standards largely due to increased efficiency, very low funding costs, reduced impairments and stable commission income. This paper describes the banking sector of Lithuania in the post-crisis environment and argues that the post-crisis structural changes in general had positive effects on the banking sector’s resilience and in the first instance on profitability. In particular, high concentration of the sector was likely to help banks achieve higher efficiency while reduced risk tolerance had direct positive effects on lower impairments as well as indirect effects on lower funding costs. On the other hand, good profitability of the sector has been largely dependent on two largest market participants while smaller banks and branches had less prosperous profitability prospects. In the environment where large banks appear to have particularly good cost management practises, the possibilities for entry of new market players of significant size are plausible only if the newcomers are able to reach the prevailing level of high efficiency. However, without a sizeable market share this might be difficult to achieve.

    The views expressed are those of the author(s) and do not necessarily represent those of the Bank of Lithuania.

No 20
2018-04-06

Application of the integrated accounts framework for empirical investigation of the economic and financial cycle in Lithuania

  • Abstract

    By resorting to the analytical integrated accounts framework, this paper investigates the relationship between economic and financial imbalances during the recent economic and financial cycle in Lithuania. There is clear evidence from the financial accounts data that there was a pronounced expansion of balance sheets of institutional sectors during the phase of the economic upturn, whereas the economic downturn was essentially a balance-sheet recession characterised by contracting private sector balance sheets and the reversal in credit flows and monetary dynamics. The boom-and-bust cycle was strongly associated with exuberant bank lending during the boom years, followed by a sudden reversal of lending conditions and the subsequent repatriation of debt financing by foreign banks.
    The Lithuanian experience also confirms that strong credit and asset price boom accompanied by economic imbalances, and debt financing of current account deficits in particular, is a potentially risky mix of economic conditions. The policy response to crisis was a market-imposed austerity but nevertheless there was a sharp rise in public debt, essentially offsetting deleveraging in the private sector. The effective replacement of growth of private sector debt with a rapid accumulation of public debt was a very important stabilising factor.
    Certain characteristics of bank credit (namely, its partial self-financing) imply that under some conditions economic stabilisation could have been achieved through domestic financing. However, the government had to resort to foreign financing, which was rather costly. During the crisis the monetary dynamics was driven by government borrowing from abroad, stepped up capital transfers from abroad and positive current account adjustments, all of which allowed foreign parent banks to withdraw debt financing and replace it with domestic deposit financing.

    The views expressed are those of the author(s) and do not necessarily represent those of the Bank of Lithuania.

No 5
2018-04-06

Credit and money creation from the integrated accounts perspective

  • Abstract

    In this paper we apply the analytical integrated accounts framework to conduct a conceptual analysis of essential macrofinancial linkages. In particular, we analyse the macroeconomic mechanism of the creation of purchasing power through bank credit, explore the partial self-financing property of bank credit and the links between bank credit and money creation, and discuss the role of debt accumulation as a powerful demand-side driver of growth. We argue that creation of money and purchasing power is an indispensable corollary of bank credit issuance. Contrary to conventional wisdom, credit is not predicated on existing savings. It directly adds to domestic demand, which translates into some combination of stronger domestic economic activity, stronger foreign economic activity or higher prices, with particular configuration depending on the structural features of the economy. However, credit-driven growth may result in a systemic over-reliance on continuous debt accumulation and poses the risk of deep structural imbalances and balance sheet recessions.

    JEL Codes: E51, E58, G21.

    The views expressed are those of the author(s) and do not necessarily represent those of the Bank of Lithuania.

No 19
2018-03-29

Review of the price dynamics in Lithuania in 2013–2017

  • Abstract

    To analyse inflation in Lithuania and determine inflation trends in the long run, the paper identifies long-term factors, namely the Eurosystem’s monetary policy and economic convergence. The main objective of the Eurosystem is to maintain price stability, defined as annual inflation rates below, but close to, 2% over the medium term. However, due to economic convergence, inflation rates of Central and Eastern European (CEE) countries can be around 1 to 3 percentage points higher than, for example, those of the older EU Member States. This is influenced by the participation in the EU single market, which promotes equalisation of prices and wages in the EU, and the fact that less developed countries of the EU exhibit relatively more rapid economic growth. The latter determines the convergence of the CEE countries’ income levels with the income levels of the more developed EU countries, and adds further pressure on inflation.
    Lithuania’s inflation dynamics over the analysed period were also underpinned by various factors that caused inflationary fluctuations in the short and medium period, for example, domestic and foreign economic activity, international commodity prices, and administrative decisions. All these factors boosted inflation in 2017. Growth of food and beverage prices in 2013–2017 amounted to around 2.2% on average, reaching 5.5% in 2017. This increase was driven not only by the growth of food commodity prices, but also by a large increase of excise duties on alcoholic beverages. Service price growth in 2013–2017 reached around 3% on average, whereas in 2017 it accelerated to 5.5%. More rapid growth in prices of services in 2017 can be explained by the prevailing tensions in the labour market: a shortage of labour force, which has put pressure on wages, and a noticeable rise in the minimum monthly wage. Although the long-term growth rate of non-energy industrial goods has been close to 0, recent improvements in the international environment and rapid growth of unit labour costs have led to an increase in corresponding prices. Finally, the development of oil prices has had an indirect effect on the evolution of the prices of all inflation components in both the short and the medium term.
    Countercyclical fiscal policies might improve the management of the economic cycle and inflation. Given that all euro area countries are under the Eurosystem’s monetary policy framework, a sustained fiscal policy would help to minimise inflationary deviations from the long-term trend of domestic economic factors. In terms of fiscal policies, the economy should not be further stimulated during an economic upturn (for example, through tax cuts or cost increases); government revenue surplus collected during cyclical upturn should be set aside in case of a downturn, thus preserving the volume of domestic demand.
    When inflation fluctuations are disadvantageous to consumers, i.e. when revenue is growing at a slower or similar pace as prices, the purchasing power of the lowest–income households should be ensured. For the low–income citizens, economic benefits brought by growing economy can be insufficient or overdue. Therefore, the purchasing power of consumers with the lowest income can be maintained through structural reforms, for example, a thorough tax system reform. With such a reform, the share of GDP reallocated should be increased. Also, in order to increase GDP reallocation, significant changes in the tax system should not be carried out in isolation, i.e. restructuring of the pension system should come hand in hand.

    The views expressed are those of the author(s) and do not necessarily represent those of the Bank of Lithuania.


    Available only in Lithuanian

No 18
2018-03-07

Leverage Ratio as a Macroprudential Policy Instrument

  • Abstract

    This paper aims to explain the relationship between risk-based and leverage ratio (LR) requirements and the motivation for the macroprudential use of LR requirements.

    The LR requirement is part of the Basel III reform, and it will be introduced as a Pillar 1 standard to supplement the existing risk-based capital requirements. Since 2015, the disclosure requirement has been in place, and banks have to regularly compute and report their LR. Both the BCBS and the EBA have confirmed that the minimum microprudential LR requirement of 3 per cent is appropriate and should become mandatory. A minimum LR requirement will act as a backstop for risk-weighted capital requirements, by ensuring that a financial institution has a minimum level of equity.

    A minimum LR requirement serves as the ultimate backstop against the shortage of equity based on risk-weighted capital requirements. The LR limits the exposure a bank can accumulate in relation to existing capital. It is calculated by dividing the amount of high-quality capital of a financial institution by its total non-risk-weighted exposure. The LR requirement adds an important backstop to the situation when observed risk levels differ significantly from actual unobserved levels, which could materialise quickly. There are merits to using LR requirement add-ons on a macroprudential basis as the internationally agreed-upon LR minimum (3%) might be an insufficiently effective addition to the robust capital framework. A handful of countries, such as the UK, US, Norway and Switzerland, use LR add-ons applied on top of the minimum microprudential LR requirement. However, none of the countries thus far follow a single, common framework when it comes to setting the LR requirement. In addition, when one takes into account recent research on optimal risk-weighted capital levels, the internationally agreed-upon minimum LR requirement of 3 per cent seems to lack effective backstopping power.

    The views expressed are those of the author(s) and do not necessarily represent those of the Bank of Lithuania.

No 17
2018-02-20

Sustainability of general government finances in Lithuania and other Baltic countries

  • Abstract

    The analysis of estimates of sustainability indicators of general government finances shows that the mid-to-long term risk to the sustainability of Lithuania’s general government finances is higher than the respective risk for Latvia or Estonia. The lower score results from the impact of ageing-related expenditure, the bulk of which goes towards pension benefits. However, the previous estimates of sustainability indicators of general government finances do not take into account the changes to Lithuania’s state social insurance system, which were adopted in 2016 and will come into effect in 2017 and 2018. The analysis shows that when taking into account these changes, the evolution of old-age pension expenditure in Lithuania becomes more aligned with the expected developments in other Baltic countries hence the country’s fiscal sustainability score should become similar as well.
    Long-term developments in the ratio of old-age pension expenditure to GDP are driven by demographic factors, factors stemming from pension arrangements as well as the country’s macroeconomic situation. Population ageing-related factors will put upward pressure on pension expenditure in all three Baltic countries in the long term. This impact, however, will be offset by the decreasing generosity of the pension system, the rising retirement age and the increasing employment rate. As a result, the old-age pension expenditure-to-GDP ratio will decrease by 2060 in all Baltic states.
    Even though the situation of pension systems of all Baltic countries may look sustainable in the long term from a formal point of view, i.e. when measured in terms of financial flows (the ratio between pension expenditure and GDP will decrease by 2060), the key factor underlying sustainability, i.e. the decreasing ratio of the average pension to the average wage, raises serious doubts. This ratio implies a substantial future decrease in the generosity of the pension system and insufficient adequacy of old-age pensions. The assessment of fiscal sustainability, which disregards the adequacy of the pension system, is too narrow and limited. The anticipated low old-age pension-to-average wage ratio might act as a deterrent to participation in the social insurance system. Therefore, the authorities would likely end up seeking resources to increase pensions, which would undermine fiscal sustainability. In a scenario which implies no change in the old-age pension replacement rate from its current level and which looks the most feasible due to political risks, Lithuania’s fiscal sustainability score is likely to be lower than estimated by the European Commission, which points to the need to take measures that could ensure fiscal and social sustainability.
    The alternative scenario analysis of Lithuania’s pension expenditure–to-GDP ratio indicates that some measures could partly offset the effect of ageing. The analysis of various demographic scenarios indicates that population ageing is inevitable in Lithuania, i.e. the proportion of older persons in the population will increase compared to the proportion of the working age group. This implies that an increasing share of the budget will have to be allocated for old-age pensions and that the replacement rates of the first pillar pensions will be negatively affected. Such measures as increasing labour market activity, promoting employment, and raising the retirement age could increase sustainability of Lithuania’s pension system in the long term.

    The views expressed are those of the author(s) and do not necessarily represent those of the Bank of Lithuania.


    Available only in Lithuanian

No 48
2017-12-11

R&D, growth, and macroprudential policy in an economy undergoing boom-bust cycles

  • Abstract

    Recent evidence suggests that credit booms and asset price bubbles may undermine economic growth even as they occur, regardless of whether a crisis follows, by crowding out investment in more productive, R&D-intensive industries. This paper incorporates Schumpeterian endogenous growth into a DSGE model with credit-constrained entrepreneurs to show how shocks affecting firms' access to credit can generate boom-bust cycles featuring large fluctuations in land prices, consumption, and investment. During the expansion, rising land prices tend to crowd out capital and (especially) R&D investment: in the long run, this results in lower productivity levels, which in turn implies lower levels of aggregate output and consumption. Moreover, higher initial loan-to-value ratios tend to be associated with larger macroeconomic fluctuations. A counter-cyclical LTV ratio targeting credit growth has relevant stabilization effects but brings about small gains in terms of long-run consumption levels, and thus of welfare.

    JEL Codes: E22, E32, E44, O30, O40.

    The views expressed are those of the author(s) and do not necessarily represent those of the Bank of Lithuania.

No 16
2017-10-20

Heterogeneity in the internationalization of R&D: Implications for anomalies in finance and macroeconomics

  • Abstract

    Empirical evidence suggests that investments in research and development (R&D) by older and larger firms are more spread out internationally than R&D investments by younger and smaller firms. In this paper, I explore the quantitative implications of this type of heterogeneity by assuming that incumbents, i.e. current monopolists engaging in incremental innovation, have a higher degree of internationalization in their R&D technologies than entrants, i.e. new firms engaging in radical innovation, in a two-country endogenous growth general equilibrium model. In particular, this assumption allows the model to break the perfect correlation between incumbents’ and entrants’ innovation probabilities and to match the empirical counterpart exactly.

    JEL Codes: E22, F31, G12, O30, O41.

    The views expressed are those of the author(s) and do not necessarily represent those of the Bank of Lithuania.

No 47
2017-10-05

Technology trade with asymmetric tax regimes and heterogeneous labor markets: Implications for macro quantities and asset prices

  • Abstract

    The international diffusion of technology plays a key role in stimulating global growth and explaining co-movements of international equity returns. Existing empirical evidence suggests that countries are heterogeneous in their attitude toward innovation: Some countries rely more on technology adoption while other countries rely more on internal technology production. European countries that rely more on adoption are also typically characterized by lower fiscal policy flexibility and higher labor market rigidity. We develop a two-country model, in which both countries rely on R&D and adoption, to study the shortand long-run effects of aggregate technology and adoption probability shocks on economic growth in the presence of the aforementioned asymmetries. Our framework suggests that an increase in the ability to adopt technology from abroad stimulates future economic growth in the country that benefits from higher adoption rates but the beneficial effects also spread to the foreign country. Moreover, it helps to explain the differences in macro quantities and equity returns observed in the international data.

    JEL Codes: E3, F3, F4, G12.

    The views expressed are those of the author(s) and do not necessarily represent those of the Bank of Lithuania.

No 46
2017-09-20

Optimal long-run inflation and the informal economy

  • Abstract

    This paper studies the optimal long-run rate of inflation in a two-sector model of the Lithuanian economy with informal production and price rigidity in the regular sector. The government issues no debt and is committed to follow a balanced budget rule. The informal sector is unregulated and untaxed and its existence limits the government’s ability to collect revenues through fiscal policy. Such environment provides therefore the basis for quantifying the possible existence of a public finance motive for inflation. The main results can be summarized as follows: First, there is a strong heterogeneity in the optimal inflation rate which depends on the tax rate that is endogenously adjusted to keep the budget balanced. Inflation can be as high as 6.77% when the capital tax rate is endogenous, but when labor income taxes are adjusted optimal policy calls for a rate of deflation such that the nominal interest rate hits the zero lower bound. Second, the optimal inflation rate is a non-decreasing function of the size of the informal economy and, in most cases, there is a positive relationship between the two. Finally, substantial deviations from zero inflation are observed even in presence of a plausible degree of price rigidity.

    JEL Codes: E26, E52, H26.

    The views expressed are those of the author(s) and do not necessarily represent those of the Bank of Lithuania.

No 15
2017-08-18

Synchronicity of real and financial cycles and structural characteristics in EU countries

  • Abstract

    In this paper, we examine the relationships between real, credit and house price cycles, by using a synchronicity index, and structural characteristics and macroeconomic variables of 17 EU countries. We find that the cycles between credit variables and the real cycle with the property or equity prices cycles seem relatively well synchronised. Credit and GDP fluctuations seem to be less synchronised, mostly because credit volumes tend to lag the real cycle by several quarters. The high rates of private homeownership tend to be associated with larger cycles in GDP, credit, and house prices. Higher Loan-To-Value ratios, seen as a proxy of borrowing constraints, and a higher percentage of flexiblerate mortgages, could also indicate that a country is more sensitive to shocks and possibly increase pro-cyclicality and increase cycle volatility. Finally, the pro-cyclicality of the credit and housing market to the GDP cycle can be linked to the fluctuation in current accounts and their misalignments with respect to the theoretical equilibrium value. The synchronicity and the cycles of credit may also be considered for signaling recessions.

    JEL Codes: E32, E44, F36.

    The views expressed are those of the author(s) and do not necessarily represent those of the Bank of Lithuania.

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