Professional Documents
Culture Documents
What is money?
Medium of Exchange
Classical
view Keynesian
Unit of account
and
Monetarist
Standard for differed payment View
Store of Value
Value of Money 1
P
1
Objective Targets and Instruments of Monetary Policy
Ultimate objective: stability (P, r, E), high growth rate of
output, low unemployment rate
2
Bank of Englands View on Transmission Mechanisms of Monetary Policy:
How Does Money Supply Affect the Price Level?
i,r,er,Pe P
Market C+I+G
rate MS Domestic Y Domestic
Official demand inflationary pressure
rate Total demand
Asset
prices Inflation
Net external
Expectations demand
and confidence
Import
prices
X,M
Exchange
rate
Fisher Equation
i
i0 rn
r
0 t0 T time
Monetary policy can have some real effect in the short run but not in the long run.
Short runs become shorter with more accurate expectations
5
Transmission Mechanisms of Monetary Policy
6
Open Market Operation: Interest Rate Channel
Short run:
Central bank raises the repo rate
Commercial banks and financial institutions
find it profitable to buy bonds from the
central bank
Central bank sell bonds and reduces reserves of the
financial institutions
Commercial banks have less money to lend
Firms and households find it expensive to borrow
They pay back loans and close deposits accounts
Demand for goods and services falls
Money supply contracts
Long run:
Prices will eventually fall
Real money supply increases
Interest rises back to natural position
8
Assets and Liabilities of the Financial System of An Economy
Central bank
Assets Liabilities
Loans to the government Currencies in circulation M4
Loans to the commercial banks Monetary Reserves of the commercial banks
Foreign asset (currency) Deposit of the government RESERVE
Gold and other precious metals
Base Claim by foreigners and Net worth
Commercial banks
Assets Liabilities
Loans to the government Deposits of private sector
Loans to the private sector Deposit of the government sector
Reserves and deposit at the central bank Obligation to foreigners
Claim on foreign assets Network
Government Sector
Assets Liabilities
Deposit with the commercial banks Borrowing from the central bank
Deposit with the central banks Borrowing from the private sector
Loans to foreigners Foreign debt
Other assets Network
Private sector
Assets Liabilities
Deposit at commercial banks Loans from the banking system
Tangible wealth Payment due to the government
Currency and precious metal Network
9
Quantity Theory of Demand for Money: Classical View
M
Cambridge equation of money demand: P kY =>
1
M PY
k
If Y and V are constants how does the relation between
prices and money supply look like?
MV=PY
P
M
Classical dichotomy: Price level is proportional to the
supply of money; no link between monetary and real
sectors.
No link between supply of money and the interest rate and
the real side of the economy; missing link for Keynes.
10
Link between Money Stock Price Level, Inflation,
Nominal interest Rate in the Classical Model
Money
Supply Price Level Inflation Nominal
Interest
rate
Money
Demand
11
Keynesian View on Monetary Policy : Main Points
Monetary affects real economy through the interest
rate.
12
Keynesian View on Monetary Policy : Main Points
M Increase in MS
kY r Lower interest rate
Reduced cost of Investment
P More investment
More Aggregate Demand
Bonds = Financial Wealth (M/P) But
Keynes Favours Fiscal Policy
Monetarist Model:
Monetary policy more
Keynesian Model
Effective
Fiscal Policy is
more effective i M
k r e, rb, r D , r Y
P
a bT I 0 qr G
Y
1 b
i LM0
b 1 M IS1
a r kY
P
c LM1 IS0
IS1 LM0
Is0 LM1
Y Y
Small Change in public Spending Small Change in money supply
has a larger output effect than a has a larger output effect than a
Larger change in money supply bigger change in public spending
16
Money Supply
Various types of money: M0, M1, M2, M3, M4 ;
Money multiplier: m1
r where r DR
M kY 1
M PY
=>
P k
M kPY => M k r e
,
r b , r D , r
PY
18
Friedman (1968) on Monetary Policy
Given the natural rates of interest and unemployment,
monetary policy cannot be pegged to lower the interest
rate or the unemployment. Is so it only raises inflationary
expectation and increase in price level. There will be no
impact on real magnitudes.
19
Contribution of Monetarism in
Macroeconomic Policy
Supply of money is the determinant of the national
income
In the long run, the influence of money is primarily
on the price level and other nominal magnitudes.
Real output and employment are not determined by
monetary factors.
In the short run the supply of money does affect the
output. Money is the dominant factor in causing
cyclical fluctuations in output and employment in
the short run.
Private sector is inherently stable and instability is
primarily the result of the government policy.
20
Exercises
21
The Financial System,
Money Demand,
and Monetary Policy
Pierre-Richard Agnor
The World Bank
22
l The Financial System
l Indirect Instruments of Monetary Policy
l Credit Rationing
l Monetary Policy in a Dollarized Economy
l The Demand for Money
23
Key features of financial system in
developing countries :
l low degree of institutional diversification;
l limited availability of financial assets;
l importance of government intervention.
24
The Financial System
l Figure 2.1.
l Financial Repression
l Banks and Financial Intermediation
25
Fi
gu
r
e2
.
1
a
F
i
n
anc
i
a
lDe
p
t
h
an
dPe
r
Ca
p
it
aI
n
co
me
1
/
(
A
ve
r
ag
e
ov
e
r
19
8
0-
9
5)
5
0
N
a
r
r
o
wMo
n
e
y(
i
np
er
c
e
nt
of
GD
P)
4
0
3
0
2
0
1
0
0
0 5
0
0
0 1
0
0
0
0 1
5
0
0
0 2
0
0
0
0
P
e
r
c
ap
i
t
ar
ea
l
GDP
i
n1
98
7
U
Sd
o
l
l
ar
s
S
o
u
rc
e:
Wor
l
dB
an
k.
1
/
4
4de
ve
l
op
in
gc
ou
nt
r
i
es
an
d15
i
nd
us
t
r
ia
l
i
zed
c
ou
nt
r
ie
s
ar
ei
n
cl
ud
ed
.
Ad
ar
k
ci
r
cl
er
ef
e
rs
t
o
d
e
v
el
o
pi
ng
co
un
tr
i
e
san
da
li
g
ht
er
c
ir
c
l
et
oi
n
dus
t
r
i
al
co
un
t
r
ie
s
.
26
Fi
gu
r
e2
.
1
b
F
i
n
anc
i
a
lDe
p
t
ha
nd
Pe
r
Ca
pi
t
aI
nc
o
me
1
/
(
A
ve
r
ag
e
ov
e
r
19
8
0-
9
5)
1
4
0
B
r
o
ad
Mo
n
e
y(
i
np
er
c
en
t
of
GD
P)
1
2
0
1
0
0
8
0
6
0
4
0
2
0
0
0 5
0
0
0 1
0
0
00 1
5
0
00 2
0
0
00
P
e
r
c
ap
i
ta
r
ea
l
GDP
i
n1
98
7
U
Sd
o
ll
a
rs
S
o
u
rc
e:
Wor
l
dBa
nk
.
1
/
44
dev
e
l
op
in
gco
un
t
r
i
esa
nd1
5
i
nd
us
t
ri
a
li
ze
dc
ou
nt
r
ie
sa
r
ein
c
l
ud
ed
.
Ad
ar
k
ci
r
cl
er
ef
e
rs
to
d
e
v
el
op
i
ng
co
unt
r
i
esa
n
dal
i
gh
te
r
c
ir
c
l
et
oi
ndu
st
r
i
al
co
un
t
ri
e
s.
27
Financial Repression
State of financial repression is defined as:
l ceilings on nominal interest rates;
l quantitative controls and selective credit
allocation across government considered priority
sectors, regions or activities;
l high minimum reserve requirement;
l loan decisions of state owned banks are guided by
political factors;
l forced allocation of assets or loans to the public
sector by private commercial banks, for example,
statutory liquidity ratios (required to hold a
proportion of assets in the form of government debt).
28
Interest rate ceiling may distort the economy by:
l increasing the preference of individuals for current
consumption as opposed to future consumption, as
a result, by reducing savings;
l reducing the supply of funds through the banking
system (disintermediation);
l leading bank borrowers to choose more capital-
intensive project due to low interest rate on loans;
l financing low-yielding project more heavily.
l Motivation for financial repression: inability to raise
taxes either due to administrative inefficiencies
or political constraints.
29
l Government manipulates the financial system to
promote its development goals through financial
repression.
l Financial repression yield substantial revenue to the
government.
l First source: implicit tax on financial
intermediation by high reserve requirement rates.
l Second source: implicit subsidy; government
benefits by obtaining access to central bank
financing at below-market interest rates.
l Giovannini and De Melo (1993): on average,
governments in their sample of developing
countries extracted about 2% of GDP in revenue
from financial repression. 30
Implications of financial repression:
l severe inefficiencies;
intermediation;
increase the spread between deposit and
lending rates;
and reduce saving and investment in the
economy;
l arise informal modes of financial
intermediation;
alter substantially the transmission process of
monetary policy.
31
Banks and Financial Intermediation
l Banks dominate the financial system in most
developing countries.
l Bank deposits: most important form of household
savings.
l Bank loans: most important source of finance for
firms.
l Figure 2.2: share of domestic credit provided by
banks in proportion to GDP is high.
l Equity markets: increase in size in several
developing countries (Figure 2.3).
32
F
i
g
ur
e2
.
2
a
D
o
m
e
st
i
cCr
e
di
t
Pro
v
i
d
edb
y
B
an
k
i
ng
Se
c
t
o
r
(
I
np
er
c
en
t
of
GD
P)
1
9
9
0 1
9
9
5
A
f
r
i
ca A
s
i
a
B
e
n
i
n B
a
n
g
l
ad
es
h
B
u
r
u
nd
i I
n
di
a
C
t
ed
'
Iv
oi
r
e
I
n
do
ne
s
i
a
E
t
h
i
opi
a
K
o
r
e
a
G
a
b
o
n
G
h
a
n
a M
a
l
a
ysi
a
K
e
n
y
a P
a
k
i
s
ta
n
M
a
l
a
wi
P
h
i
l
i
ppi
n
es
N
i
g
er
ia
S
i
n
gap
o
r
e
T
a
n
z
an
i
a
S
r
i
La
nk
a
Z
a
m
bi
a
Z
i
mb
ab
w
e T
h
a
i
l
an
d
0 5
0 1
0
0 02
04
06
08
01
001
2
01
40
S
o
u
r
ce
:
Wo
rl
dBa
n
k
.
33
F
i
g
ure
2
.
2b
D
o
m
es
t
i
cCr
e
di
tP
ro
v
i
de
db
y
Ba
n
k
in
gS
e
c
t
or
(
I
np
er
c
en
to
f
GDP
)
1
9
9
0 1
9
9
5
L
a
t
i
nAm
e
r
i
c
a M
i
dd
le
Ea
s
t
an
dN
o
r
t
hA
fr
i
c
a
A
r
g
en
ti
na A
l
ge
ri
a
B
o
l
i
vi
a E
g
y
pt
B
r
a
zi
l
J
o
r
da
n
C
h
i
l
e
M
a
u
r
i
ta
ni
a
C
o
l
omb
i
a
M
o
r
o
cc
o
C
o
s
t
aR
ic
a
E
c
u
ad
o
r O
m
a
n
H
o
n
du
r
a
s S
a
u
di
Ara
b
i
a
J
a
ma
i
c
a
S
y
r
i
a
M
e
x
i
c
o
T
u
n
i
si
a
P
e
r
u
T
u
r
k
ey
U
r
u
gu
ay
V
e
n
ez
u
e
la Y
e
m
en
0 5
0 1
0
0 0 3
5 7
0 1
0
5 1
4
0
S
o
u
r
ce
:
Wor
l
dBa
n
k
. 34
F
i
gur
e2
.3
S
t
oc
kM
a
rk
e
tC
ap
i
t
al
iz
at
i
on
(
I
npe
r
c
ent
of
GDP
)
1
9
90 1
9
95
A
r
g
ent
i
na K
o
r
ea
B
r
a
zi
l M
e
x
i
co
C
h
i
l
e M
o
r
o
cc
o
C
o
l
omb
i
a N
i
ger
i
a
t
ed'
I
voi
r
e P
a
k
i
st
an
E
c
u
ad
o
r P
e
r
u
E
g
y
pt P
h
i
l
i
ppi
nes
G
h
a
na S
r
i
Lan
k
a
I
nd
ia T
h
a
il
and
I
nd
on
e
si
a T
u
n
is
i
a
J
o
r
da
n T
u
r
ke
y
K
e
n
ya V
e
n
ez
u
el
a
02
0406
0801
0
012
01
40 02
0406
0801
001
2
014
0
S
o
u
rc
e
:W
or
l
dBa
n
k.
N
o
t
e:
St
ock
ma
r
ke
tca
p
it
al
i
zat
i
oni
st
hes
h
ar
ep
ri
cet
i
mes
t
hen
u
mb
e
ro
f
sha
r
e
sou
t
s
tan
d
i
ngf
or
al
ll
i
st
ed
d
o
me
st
i
cco
m
pa
ni
es
.
35
Results of development in equity markets:
l allow greater dispersion of risk;
l more efficient allocation of resources;
l greater mobilization of savings;
l active secondary markets in government debt help
to conduct monetary policy through indirect
instruments.
l In most developing countries, corporate bond
markets remain quite narrow, concentrated, and
relatively illiquid.
36
Main functions of banks:
l transformation: transform the short-term, liquid
deposits held by households into illiquid liabilities
issued by firms;
l delegated screening and monitoring: screen
potential borrowers and monitor actual borrowers
on behalf of depositors;
l facilitate transactions : between agents (firms and
workers, buyers and sellers) by providing payment
services.
37
Problems in banking system:
l Inadequate prudential supervision: create
systemic fragility and may precipitate bank runs and
currency crises.
l This complicates the conduct of monetary policy
since banks that are less able to control their
balance sheets will be less responsive to changes
in the base money stock or interest rates.
l Problems may lead to pressure on the central bank
to extend credit to bail out troubled banks.
38
Indirect Instruments of
Monetary Policy
39
l Under financial repression central banks use direct
instruments of monetary policy.
Problems:
l create severe inefficiencies in credit allocation and
the financial intermediation process;
l lose effectiveness of direct instruments since agents
start to rely on informal credit channels.
l As a result, many countries have liberalized their
financial systems and adopted indirect instruments
of monetary management.
l Indirect instruments of monetary policy are market
based and operate essentially through interest
rates.
40
l Main purpose: affect overall monetary and credit
conditions through changes in the supply and
demand for liquidity.
l Indirect instruments:
open-market operations;
reserve requirement.
Open-market operations:
l The direct sale or purchase of financial instruments
(treasury bills or central bank paper) in the
secondary market for securities or through central
bank intervention in primary markets for securities
to influence the level of liquid reserves held by
commercial banks. 41
l Repurchase agreements: acquisition of financial
instruments by the central bank under a contract
stipulating an agreed date and a specified price for
the resale of these instruments; and reverse
repurchase agreements.
l In contrast with direct operations, these agreements
provide temporary financing of cash shortages and
surpluses, but do not directly influence supply and
demand in the instrument used as collateral.
Refinance and discount facilities:
l Short-term lending operations that involve
rediscounting high-quality financial assets (such as
treasury bills) by the central bank.
42
Reserve requirements:
l Remunerated reserve requirements: commercial
banks must hold a specified part of their assets in
the form of reserves at the central bank.
l All these instruments allow policymakers to exercise
greater flexibility in implementing monetary policy.
l Process of financial liberalization accompanied by
increased reliance on the use of indirect
instruments in developing countries.
43
Problems in conduction of open-market
operations:
l If volume of central bank transactions is larger than
total volume of transactions in the secondary market,
sales of government securities by the central bank
may lead to a rise in interest rates on these securities
l This raises the domestic debt burden of the
government.
l In this case, repurchase operations may be
preferable.
l Other problem: conflict arises between monetary
management objectives and debt management
objectives when monetary policy relies on primary
market sales of government securities. 44
Credit Rationing
45
l Because of imperfect or asymmetric information
between banks and borrowers, probability that the
borrower will actually repay the loan is less than
unity.
l Stiglitz and Weiss (1981) showed credit rationing
may emerge endogenously.
Credit Rationing:
l As the interest rate on the loan increases, the
probability of repayment may decline.
l Banks has less incentive to lend in such conditions
and they may even stop lending completely.
46
Stiglitz-Weiss model:
Assume:
l Economy populated by a bank and a group of
borrowers, each of whom has a single, one-period
project in which he (or she) can invest.
l Each project requires a fixed amount of funds, L,
and this is the amount that each borrower must
obtain to implement the project.
l Each borrower must pledge collateral in value C <
L.
l Each project requiring funding has a distribution of
gross payoffs, F(R,);
R: project's return and borrower cannot affect it;
min {R + C ; (1+r) L}
l Return to the borrower:
max {R - (1+r) L; - C}
l For a given contractual interest rate,~ r, there is a
~
critical value of , say , such that an agent will
borrow to invest if, and only if, > .
l Interest rate serves as a screening device.
49
Increase in r triggers two types of effects:
l adverse selection effect (rise in the threshold
~
value ):
by increasing the riskiness of the pool of
51
Figure 2.4:
l Ld: demand for loanable funds; Ls: supply of
loanable funds; both as functions of the contractual
loan rate, r.
l Ld: negative function of r.
s ~
l L : positively related to r only up to r.
~
increases in r beyond r trigger adverse
selection and incentive effects, which lead to
decreasing amounts of credit offered to
borrowers.
Thus, Ls curve has a concave shape.
52
F
i
gur
e2.
4
I
nt
er
est
Rat
eDe
te
rmi
nat
ion
i
nth
eS
t
ig
li
t
z-We
is
sCr
ed
i
tRati
oni
ngM
o
d
el
d
L
e
x
ce
ss
d
e
ma
nd
As
L
4
5
s ~
L r r
S
o
ur
c
e:A
da
p
te
df
r
omS
t
i
gl
it
zan
dW
ei
ss(
19
81
,
p.3
97
)
. 53
l is the product of r and the probability of
repayment.
l Owing to the adverse selection and incentive
effects, the repayment probability declines by more
than the increase in r beyond ~r.
l So the relationship between and r is
nonmonotonic (RR curve) and RR is more concave
shape than Ls.
l There is a positive relationship between and Ls
(Southwest panel of Figure 2.4).
l The northwest panel shows a 45-degree line
mapping of the equilibrium loan amount and Ls.
54
l Point A gives value of r that ensures equality
between Ls and Ld.
l Credit-rationing equilibrium occurs at the interest
~
rate r, where is at its maximum level.
l Market-clearing interest rate is not optimal for the
bank, because at that level bank profits are less
than at ~r.
l It is also inefficient, because borrowers with high
repayment probabilities drop out and are replaced
by those with high default risk.
55
~
l The non-market-clearing rate r is both optimal and
efficient, because bank profits are at a maximum
level and risky borrowers are rationed out.
l Thus, under imperfect information, lending rates
that are below market-clearing levels can be
observed even in competitive credit markets.
l Such non-market-clearing lending rates reflect an
efficient response to profit opportunities.
Implication:
l Increases in interest rates, beyond credit-rationing
level, can be counterproductive.
56
l Stiglitz-Weiss model is helpful to understand why in
some developing countries bank credit is severely
rationed with bank lending rates unresponsive to
excess demand for credit.
l Kaufman (1996) used the Stiglitz-Weiss model to
explain some of the aspects of Argentina's
economic crisis of 1995-96.
l Degree of riskiness of projects can be
endogenously related to the level of economic
activity---which itself depends on the amount of
loans available.
l This link creates a channel through which credit
rationing can be exacerbated and may display
persistence over time.
57
l Stiglitz-Weiss model may also be useful to explain
the high holdings of excess reserves by
commercial banks in developing countries.
l In an environment in which the probability of default
on loan commitments is high, excess reserves will
also tend to be high.
l Figure 2.5: evolution of excess liquid assets held by
deposit money banks in Thailand, before and after
the financial and economic crisis that erupted in mid
1997.
l Very sharp increase in excess liquidity in the
immediate aftermath of the crisis.
l But this increase could also be, at least in part,
demand induced. 58
F
i
g
ur
e2
.
5
T
h
a
i
l
an
d:
Ex
ce
s
s
Li
q
ui
dAs
s
e
ts
,
19
96
-
9
8
(
i
np
er
c
en
t
of
t
ot
al
de
po
s
i
t
si
nc
om
m
e
r
ci
a
lba
n
k
s)
1
4
B
a
h
tC
ri
si
s
1
2 (
J
ul
y2
)
1
0
0
Jul.196
Jul.197
Jul.198
Jan.196
Apr.196
Jan.197
Apr.197
Jan.198
Apr.198
Oct.196
Oct.197
Oct.198
S
o
u
r
ce
:
Ba
nk
o
f
Th
ai
l
an
da
n
d
In
t
e
rn
at
i
on
al
Mon
e
t
a
ry
Fu
n
d
.
59
In general, nevertheless, the effectiveness of
monetary policy actions depends importantly on
l whether banks are holding excess liquid reserves or
not;
l degree to which interest rates can be deemed
sensitive to changes in excess reserves;
l degree to which bank lending decisions are
influenced by the perceived riskiness of potential
borrowers.
Limitations of Stiglitz-Weiss model:
l Assumption that lenders are completely unable to
assess the degree of riskiness of potential
borrowers.
60
Banks have incentives to invest in screening
technologies in order to acquire information
about the risk characteristics of their customers.
This is particularly plausible in a dynamic context.
l Role of collateral, C:
Wette (1983): adverse selection effects similar to
63
Monetary Policy in a
Dollarized Economy
64
l Dollarization (currency substitution): foreign
currency is used as a unit of account, store of value,
and a medium of exchange, concurrently with the
domestic currency.
l Figure 2.6: dollarization (proportion of foreign
currency deposits held in the banking system
relative to the domestic broad money stock) has
been at times pervasive.
l Figure 2.7: dollarization ratio grew significantly
during the period, in line with the increase in
inflation rates in Turkey.
65
S
o
u
r
c
e
:I
n
t
er
n
at
i
o
na
lM
o
ne
t
a
r
yF
un
d
.
11
91
9
89
1
8
59
8
q1
1
9
q9
1
1q
4
18
9
1
q5
8
9
1
11q
8
9
0 0
5 5
10 10
15 15
20 20
25 25
30 30 Bo
(
I
n
pr
o
po
r
t
i
on
o
ft
h
ed
o
me
s
t
i
c
br
oa
d
m
on
e
y
s
t
oc
k
)
F
o
r
e
i
gn
Cu
r
r
e
nc
y
De
p
o
s
i
t
sH
el
d
in
th
e
D
om
e
s
t
i
cB
an
k
i
n
gSy
s
t
e
m
F
i
g
ur
e2
.
6
a
66
F
i
g
ur
e2
.
6
b
F
o
r
e
i
g
nCu
r
r
e
nc
y
De
p
o
s
i
t
sH
el
d
in
th
e
D
om
e
s
t
i
cB
a
nk
i
n
gSy
s
t
e
m
(
I
n
pr
o
po
r
t
i
o
no
ft
h
ed
o
me
s
t
i
c
br
oa
d
m
on
e
y
s
t
oc
k
)
5 Me
3
4 2.5
2
3
1.5
2
1
1
0.5
0 0
19
18
9
15
8
9
1q
8
9
9q
1
9
11
9
1q
4
1q
8
9
11
5
8
9
11q
8
9
S
o
u
r
c
e
:I
n
t
er
n
at
i
o
na
lM
o
ne
t
a
r
yF
un
d
.
67
F
i
g
ur
e2
.
6
c
F
o
r
e
i
gn
Cu
r
r
e
nc
y
De
p
o
s
i
t
sH
el
di
nt
h
eD
om
e
s
t
i
c
Ban
k
i
n
gSy
s
t
e
m
(
I
n
pr
o
po
r
t
i
on
of
t
he
do
m
e
s
t
ic
b
r
oa
d
m
on
e
y
s
t
oc
k
)
2 10 T
8
1.5
6
1
4
0.5 2
0
0 1 9
18
9
1 5
8
9
1q
8
99
19
18
9
15
8
91q
8
9
9q
19
1q
41q
11
S
o
u
r
c
e
:I
n
t
er
n
at
i
o
na
lM
o
ne
t
a
r
yF
un
d
.
68
S
o
u
r
c
e
:I
n
t
er
n
a
ti
o
na
l
Mo
n
et
a
r
yF
u
nd
a
n
d
of
f
i
c
i
al
es
t
i
ma
t
e
s.
1
9
8
81
99
01
9
9
21
99
41
9
9
6 1
9
8
81
99
01
9
9
21
99
41
9
9
6
-
6 3
0
-
4 4
0
-
2 5
0 I
n
f
l
at
i
o
n
6
0
0
7
0
2
8
0
4
9
0
6 D
o
m
e
s
t
i
cc
r
e
di
t
gr
o
wt
h
1
0
0
8 1
1
0
1
0 1
2
0 R
e
s
e
r
v
em
o
n
ey
g
r
o
wt
h
R
1
2e
a
l
GD
Pg
r
o
w
th 1
3
0M
o
n
ey
,
c
r
ed
i
ta
n
dp
r
i
c
es
(
I
n
pe
r
ce
n
t
p
er
a
nn
u
m,
u
nl
e
ss
ot
h
e
rw
i
se
i
n
di
c
at
e
d)
T
u
r
k
e
y:
M
ac
r
oe
c
o
n
o
mi
cI
n
d
ic
a
t
or
s
,
19
8
7
-9
6
F
i
g
ur
e2
.
7
a
69
1
/
S
ha
r
eo
ff
o
r
ei
g
nc
ur
r
e
nc
y
de
p
os
i
t
si
nt
o
t
al
b
an
kd
ep
o
s
it
s
.
S
o
u
rc
e
:I
n
t
er
n
at
i
o
na
lM
o
ne
t
a
ry
F
un
d
an
dof
f
i
c
ia
l
es
t
i
ma
t
es
.
1
9
8
81
99
01
9
9
21
99
41
9
9
6 1
9
8
81
99
01
9
9
21
99
41
9
9
6
-
1
0 0
-
8 1
0
F
i
s
ca
l
ac
c
ou
n
t
b
al
a
nc
e
-
6
2
0
-
4
3
0
-
2
4
0
0
2 5
0
C
u
r
r
e
nt
a
cc
o
un
t
b
al
a
nc
e
F
i
s
4c
a
l
an
dc
u
r
r
e
nt
a
cc
o
un
t
b
al
a
nc
e(
i
n
%GD
P
) 6
0
Do
l
l
a
ri
z
at
i
on
r
at
i
o
(i
np
e
rc
e
n
t
)
1/
(
I
n
pe
r
ce
n
t
p
er
a
nn
u
m,
u
nl
e
ss
ot
h
e
rw
i
se
i
nd
i
c
at
e
d)
T
u
r
k
e
y:
M
ac
r
oe
c
o
n
om
i
cI
n
di
c
at
o
rs
,
1
98
7
-9
6
F
i
g
ur
e2
.
7
b
70
F
i
g
ur
e2
.
7
c
T
u
r
k
e
y:
Ma
c
ro
e
c
o
no
m
i
c
In
di
c
at
or
s
,
19
8
7-
9
6
(
I
n
pe
r
ce
n
t
p
er
an
n
u
m,
u
nl
e
ss
ot
h
er
w
is
e
i
nd
i
c
at
e
d)
1
0
0 D
o
m
es
t
i
c
3
0
0
90
0
0
0E
x
c
ha
n
g
e
ra
t
e
s3
/ 1
3
0
(
i
n
p
8
0
T
o
e
t
a
l
r
c
e
n
g
o
v
t
o
e
r
n
f
G
m
e
D
P{
n
t
;
l
e
d
e
b
f
t
s
t
c
a
le
) E
x
t
e
r
na
l
R
e
a
l
ef
f
ec
t
i
v
ee
xc
h
an
g
er
a
t
e
M
a
t
ur
i
t
yo
fb
o
rr
ow
i
n
g2
/ 2
5
0 (
1
9
90
=1
0
0;
r
ig
h
ts
c
a
l
e) 1
2
0
(
i
n
day
s
;r
i
g
ht
sc
a
l
e)
6
0
0
0
0
6
0
2
0
0 1
1
0
4
0
3
0
0
0
0
1
5
0 1
0
0
2
0 L
i
r
as
pe
r
USd
o
l
l
ar
(
l
ef
t
sc
a
le
)
0 1
0
0 0 9
0
1
9
881
9
9
019
9
21
99
41
9
96 1
9
881
9
9
01
99
21
9
9
419
9
6
S
o
u
rc
e
:I
n
te
r
na
t
i
o
na
lM
on
e
ta
r
y
Fu
n
da
n
d
o
ff
i
c
i
al
es
t
i
ma
t
es
.
2
/
N
ew
ly
i
ss
u
ed
d
eb
t.
3
/
Ar
i
s
ei
sa
de
p
r
ec
i
at
i
on
.
71
l Dollarization can thus be viewed as an endogenous
response by domestic agents attempting to avoid
the inflation tax and capital losses on assets
denominated in domestic-currency terms.
l It also responds to portfolio diversification needs.
l Even after sharp reductions in inflation, dollarization
can remain relatively high.
Reasons:
Guidotti and Rodriguez (1992) and Uribe
(1997b):
l Transactions costs incurred in switching from one
currency to the other.
72
l Reduction of the propensity to hold foreign currency
balances requires a very low inflation rate to induce
individuals to regain skills in the use of the domestic
currency.
McNelis and Rojas-Suarez (1996):
l Degree of currency substitution depends not only
on expectations of inflation and exchange rate
depreciation, but also on the risk (or volatility)
associated with these variables.
l In periods of low inflation (or poststabilization
episodes) risk factors become more important.
l In Bolivia and Peru, depreciation risk is an
important factor in explaining the persistence of
dollarization in low inflation situation. 73
l Dollarization is benefical, if it leads to an increase in
the flow of funds into the banking system.
l High dollarization may complicate the conduct of
monetary and exchange rate policy.
Why?
l Dollarization involves loss of seigniorage
revenue, because the demand for domestic base
money is lower.
l Outcome may be inflationary spiral, since this loss
in revenue can lead to increased monetary
financing.
74
l Dollarization affects the choice of assets that should
be included in the monetary aggregates (used as
indicators of monetary conditions or target
variables).
l Dollarization (in the form of foreign currency
deposits in domestic banks): index bank deposits to
the exchange rate.
l If loans extended against foreign-currency deposits
are denominated in domestic currency, the
currency mismatch may weaken banks' balance
sheets if the exchange rate depreciates.
75
l Dollarization affects the choice of an exchange rate
regime, because it implies short-term foreign-
currency liabilities against which foreign exchange
reserves of the banking system must be measured.
l Figure 2.8.
l High degrees of dollarization are not a cause, but
rather a symptom, of underlying financial
imbalances and weaknesses.
76
F
i
g
ur
e2
.
8
a
F
o
r
e
i
g
nCu
r
r
e
nc
y
De
p
o
s
i
t
si
nt
h
eD
om
e
s
t
i
c
Ban
k
i
n
gSy
s
t
e
m
(
I
n
pr
o
po
r
t
i
o
no
ft
o
t
al
f
or
e
ig
n
r
es
e
r
v
e
sm
i
nu
s
go
l
d
)
350 140
300 120
250 100
200 80
150 60
100 40
50 20
0 0
11
91
9
81
9
8
59
8
q1
9
1
q1
9
14
q
11
9
8
q1
9
8
5
119
8
q
S
o
u
r
c
e
:I
n
t
er
n
at
i
o
na
lM
o
ne
t
a
r
yF
un
d
.
77
F
i
g
ur
e2
.
8
b
F
o
r
e
i
g
nCu
r
r
e
nc
y
De
p
o
s
i
t
si
nt
h
eD
om
e
s
t
i
c
Ba
nk
i
n
gSy
s
t
e
m
(
I
n
pr
o
po
r
t
i
on
o
ft
o
t
al
f
or
e
ig
n
r
es
e
r
v
e
sm
i
nu
s
go
l
d
)
35 6 M
30 5
25
4
20
3
15
2
10
5 1
0 0
11
91
9
81
9
8
59
8
q1
9
1
q1
1
94
q
11
9
8
q1
1
9
8
519
9
8
q
S
o
u
r
c
e
:I
n
t
er
n
at
i
o
na
lM
o
ne
t
a
r
yF
un
d
.
78
F
i
g
ur
e2
.
8
c
F
o
r
e
i
g
nCu
r
r
e
nc
y
De
p
o
s
i
t
si
nt
h
eD
om
e
s
t
i
c
Ba
nk
i
n
gSy
s
t
e
m
(
I
n
pr
o
po
r
t
i
o
no
ft
o
t
al
f
or
e
ig
n
r
es
e
r
v
e
sm
i
nu
s
go
l
d
)
25 80 Tu
70
20
60
15 50
40
10
30
5
20
0 10
11
91
9
81
9
8
59
8
q1
9
1
q1
9
14
q
11
9
8
q1
9
8
5
119
8
q
S
o
u
r
c
e
:I
n
t
er
n
at
i
o
na
lM
o
ne
t
a
r
yF
un
d
.
79
The Demand for Money
80
l Stability of money demand is essential for the
conduct of monetary policy.
l Real money balances:
md = md(y, i, , a, ),
y: level of transactions (positive sign expected);
i, , a : domestic nominal interest rate, domestic
inflation rate, rate of depreciation of nominal
exchange rate (degree of dollarization or currency
substitution).All measure the opportunity cost of
holding money.
: variability of inflation (proxy for macroeconomic
instability); negative effect is expected.
81
Choudhry (1995):
l Focus on Argentina, Israel, Mexico (experienced
high inflation, large current account imbalances,
and drastic devaluation).
l Find stable long-run money demand function.
l Used both inflation rate and rate of currency
depreciation to measure the opportunity cost of
holding domestic money.
Results:
l Significant currency substitution effect.
l But relatively small compared with the direct effect
of inflation on money demand.
82
l In other empirical studies: include measures of
financial innovation and development.
l Financial liberalization: affect the relation between
money demand and its determinants and
complicate the conduct of monetary policy.
83
Tools of Monetary Policy
18-84
Demand in the Market for Reserves
18-85
Supply in the Market for Reserves
18-88
Affecting
the Federal Funds Rate (contd)
18-89
18-90
18-91
18-92
Open Market Operations
18-93
Advantages of
Open Market Operations
18-94
Discount Policy
Discount window
Primary creditstanding lending facility
Secondary credit
Seasonal credit
Lender of last resort to prevent
financial panics
Creates moral hazard problem
18-95
18-96
Advantages and
Disadvantages of Discount Policy
18-97
Reserve Requirements
18-98
Disadvantages
of Reserve Requirements
18-99
The Channel/Corridor System
18-101
18-102
Monetary Policy Tools
of the European Central Bank
18-103
Monetary Policy Tools
of the European Central Bank (contd)
Reserve Requirements
2% of the total amount of checking deposits and other short-term deposits
Pays interest on those deposits so cost of complying is low
18-104
Fed Monetary Policy Goals - Dual Mandate (inflation, employment)
1. Price Stability - inflation erodes value of $ as medium of exchange & unit of account.
Problems: a) Prices less useful as signals for resource allocation.
b) Uncertain prices complicate households & firms decisions.
c) Arbitrarily redistribute income.
d) Hyperinflation can severely damage econs productive capacity.
2. High Employment - unemployment GDP & causes fin & personal distress.
Congress & POTUS responsible for high employment.
Frictional & structural or natural unemployment (5-6%) - monetary policy ineffective.
Fed focused on cyclical unemployment = f(business cycle).
3. Economic Growth - GDP over time = f(high employment).
The only source of sustained real increases in household incomes.
High unemployment => unused productive capacity & investments less likely.
Stable econ growth allows accurate planning & stimulates long-run investment.
4. Stabile Fin Markets & Institutions - inefficient fin system => econ loses resources.
Fed underestimated fin crisis severity, couldnt avoid 2007-09 deep recession.
2007-09 recession made fin stability (asset bubble deflation) more important.
5. Interest Rate Stability - help stabilize fin system & planning
6. For-Ex Market Stability - help transactions planning & international competitiveness.
105
Treasury originates & Fed implements for-ex policy changes.
Monetary Policy Tools & Federal Funds Rate
During fin crisis Fed introduced two new tools connected with bank reserve accounts:
1. Interest on reserve balances (Complaint: no interest on reserve deposits = tax.
By % it pays, Fed can banks reserve holdings,
potentially landing & money supply. )
2. Term deposit facility (Similar to CDs, Fed offers them to banks in periodic auctions.
Rates slightly above rate Fed pays on reserve balances.
The more banks buy the less available to expand loans.
E.g. in October 2010 Fed auction $5B 28-day term deposits
w/ 0.27%, while rate on reserve deposits was 0.25%.)
Federal funds % banks charge each other on very short-term loans is function of
demand (banks determined) & supply for reserves (Fed determined).
The target for federal funds rate is set at FOMC meetings.
106
Equilibrium in Federal Funds Market
Equilibrium reserves (R*) & federal funds rate
(i*ff) at intersection of demand for reserves (D)
& supply for reserves (S).
107
Effects of Open Market Operations on the
Federal Funds Market
109
Analyzing the Federal Funds Market
Use graphs for federal funds market to analyze the following two situations:
How can Fed offset in bank demand for reserves Assume equilibrium federal funds % = % Fed pays on
to keep equilibrium federal funds % =. reserves. Show effect of open market purchase on
equilibrium federal funds %.
110
Open Market Operations
Open market purchase Treasuries prices & their yield (interest %), both monetary
base & money supply - expansionary policy. Open market sale is contractionary policy.
Economists generally supported the 1st round of quantitative easing but the 2nd & 3rd
rounds in Nov. 2010 & Sep. 2012 were controversial.
Opponents: monetizing national debt risk of inflation w/o effectively stimulating growth.
Supporters: like traditional open market purchases ( federal funds %) to stimulate econ.
However, since federal funds % 0, it Feds balance sheet or the monetary base.
Changing discount % or
reserve requirements
takes longer.
Since 1980, all depository institutions had access to discount window. Each Federal
Reserve Bank maintains its own discount window, although all charge same rate.
Although targets no longer favored approach, they provide insight into difficulties in
executing monetary policy. Traditionally, the Fed has relied on two types of targets:
policy instruments or operating targets (variables Fed controls directly, e.g. federal
funds % & nonborrowed reserves, that are related to intermediate targets)
intermediate targets (monetary aggregates or interest rates, use intermediate target
to achieve goal outside its control better than if focused on goal & feedback)
114
What Happened to the Link between Money and Prices?
In US money supply has grown more rapidly when inflation was relatively high.
Prior to 1980, strong evidence supports short-run (1-2 yr) link between money & prices.
Economists who argued this point most forcefully were known as monetarists.
Paul Volckers Fed shifted its policy to emphasize nonborrowed reserves as a policy
instrument. This episode of The Great Monetarist Experiment produced mixed results.
Because short-run link between money supply & inflation broke down after 1980, due to
changes in nature of M1 & M2, since 1993 Fed no longer announces M1 & M2 targets.
115
Choice between Targeting Reserves and Targeting Federal Funds Rate
Fed uses three criteria when evaluating potential variables for policy instruments:
1. Measurable: In short time to overcome information lags. Both easily measurable.
2. Controllable: Open market operations keep both close to Feds target.
3. Predictable: Complexity of impact from change in either on econ goals is a problem.
The main policy instruments are reserve aggregates (total or nonborrowed reserves)
& federal funds rate. Fed can choose one but it cannot choose both.
Using one as policy instrument will cause the other to response to changes in the 1st.
By 1980s Fed concluded that link between federal funds % & its policy goals is closer.
So, the federal funds rate has been the Feds policy instrument for the past 30 years
116
Choosing between Policy Instruments
Fed chooses reserves as its policy instrument by keeping it constant at R*.
Where inflation gap (current target inflation) & output gap (% difference RGDP
potential RGDP) have the same weight or influence on federal funds %.
If inflation > Feds target rate,
FOMC target federal funds%.
If output gap is negative
(RGDP < potential RGDP)
FOMC target federal funds %.
118
Inflation Targeting
Significant interest in inflation targeting as monetary policy framework before fin crisis.
In 2010, the Fed announced that it would attempt to maintain an average inflation rate
of 2% per year.
Arguments in favor of an explicit inflation target:
1. It would draw attention to what Fed can actually achieve in practice.
2. It would provide an anchor for inflationary expectations.
3. It would help institutionalize effective U.S. monetary policy.
4. It would promote accountability.
119
International Comparisons of Monetary Policy
Industrial countries central banks increasingly use short-term interest % as the policy
instrument through which goals are pursued.
Many central banks focus on ultimate goals (inflation) than intermediate targets.
The Bank of Japan
Used money growth targets & money growth after 1973 oil shock (inflation > 20%).
Promises fulfilment gained publics trust in commitment to money growth & inflation.
Used short-term interest rate in Japanese interbank market as its operating target.
Relied less on M2 aggregate after 1980s deregulation.
Does not have formal inflation targets, although emphasizes price stability.
Deflationary monetary policy in 1990s & 2000s significantly weakened economy.
Began to stimulate both economic growth & inflation in mid-2000s.
Intervened to soaring value against $, to stimulate exports and econ recovery.
The worlds leading central banks played a key role in bringing the financial system and the
economy back to safe harbor after the peak of the financial crisis in 2008.
They acted in unprecedented fashion to prevent the financial system from capsizing and,
over time, to restore financial and economic stability.
15-122
Introduction
15-123
Introduction
15-124
Introduction
This chapter begins to explain the role of central banks in our economic and financial
system.
It will describe the origins of modern central banking.
It will examine the complexities policymakers now face in meeting their
responsibilities.
It will highlight a central question that has become politically controversial: what is
the proper relationship between a central bank and the government?
15-125
The Basics: How Central Banks Originated and Their Role Today
The central bank started out as the governments bank and over the years added various
other functions.
A modern central bank not only manages the governments finances but provides an array
of services to commercial banks.
15-126
The Governments Bank
15-127
The Governments Bank
15-128
The Governments Bank
15-129
The Governments Bank
The central bank can control the availability of money and credit in a country's economy.
Most central banks go about this by adjusting short-term interest rates: monetary policy.
They use it to stabilize economic growth and information.
15-130
The Governments Bank
15-131
The Governments Bank
The primary reason for a country to create its own central bank, then, is to ensure
control over its currency.
Giving the currency-printing monopoly to someone else could be disastrous.
In the European Monetary Union, 16 European countries have ceded their right to
conduct independent monetary policy to the European Central Bank (ECB).
This was part of a broader move toward economic integration.
15-132
Counterfeiting has been used as a weapon in wartime.
The goal was to destabilize the enemys currency.
Without a stable currency it is difficult for an economy to run efficiently.
This is why preserving the value of a nations currency is one of the central banks most
important responsibilities.
15-133
The Bankers Bank
The political backing of the government, together with their sizeable gold reserve,
made early central banks the biggest and most reliable banks around.
The notes issued by the central bank were viewed as safer than those of smaller
banks.
The safety and convenience quickly persuaded most other banks to hold deposits at
the central bank as well.
15-134
The Bankers Bank
As the bankers bank, the central bank took on the roles it plays today:
1. To provide loans during times of financial stress,
2. To manage the payments system, and
3. To oversee commercial banks and the financial system.
The ability to create money means that the central bank can make loans even when no
one else can.
15-135
The Bankers Bank
15-136
The Bankers Bank
15-137
The Bankers Bank
Finally, someone has to watch over commercial banks and nonbank financial institutions so
that savers and investors can be confident these institutions are sound.
Those who monitor the financial system must have sensitive information.
Government examiners and supervisors are the only ones who can handle such information
without conflict of interest.
15-138
The Bankers Bank
As the governments bank and the bankers bank, central banks are the biggest, most
powerful players in a countrys financial and economic system.
However, an institution with the power to ensure that the economic and financial systems
run smoothly also has the power to create problems.
15-139
The Bankers Bank
15-140
The Functions of a Modern Central Bank
15-141
Stability: The Primary Objective of All Central Banks
What makes the private sector incapable of doing what we have entrusted to the
government?
In the cases of pollution and national defense, the answer is more obvious.
Government involvement is justified by the presence of externalities or public goods.
Economic and financial systems, when left on their own, are prone to episodes of
extreme volatility.
15-142
Stability: The Primary Objective of All Central Banks
15-143
Stability: The Primary Objective of All Central Banks
Central bankers work to reduce the volatility of the economic and financial
systems by pursuing five specific objectives:
1. Low and stable inflation.
2. High and stable real growth, together with high employment.
3. Stable financial market and institutions.
4. Stable interest rates.
5. A stable exchange rate.
15-144
Stability: The Primary Objective of All Central Banks
15-145
Low, Stable Inflation
Many central banks take their primary job as the maintenance of price stability.
They strive to eliminate inflation.
The consensus is that when inflation rises, the central bank is at fault.
The purchasing power of one dollar, one yen, or one euro should remain stable over
long periods of time.
Maintaining price stability enhances moneys usefulness both as a unit of account
and as a store of value.
15-146
Low, Stable Inflation
Prices provide the information individuals and firms need to ensure that resources are
allocated to their most productive uses.
But, inflation degrades the information content of prices.
If the economy is to run efficiently, we need to be able to tell the reason why prices are
changing.
15-147
Low, Stable Inflation
The higher inflation is, the less predictable it is, and the more systematic risk it creates.
High inflation is also bad for growth.
In cases of hyperinflation, when prices double every two to three months,
Prices contain virtually no information, and
People use all their energy just coping with the crisis so growth plummets.
15-148
Low, Stable Inflation
Most people agree that low inflation should be the primary objective of monetary
policy.
How low should inflation be?
Zero is probably too low.
There would be a risk of deflation.
This makes debts more difficult to repay, increasing default, affecting the
health of banks.
15-149
Low, Stable Inflation
15-150
High inflation is more volatile than low inflation.
Volatile inflation means more risk which requires compensation.
High inflation means a higher risk premium, so loan rates are higher.
Volatile inflation makes long-term planning even more difficult.
15-151
High & Stable Real Growth
15-152
High & Stable Real Growth
The idea is that there is some long-run sustainable level of production called potential
output, which depends on things like
Technology,
The size of the capital stock, and
The number of people who can work.
Growth in these inputs leads to growth in potential output -- sustainable growth.
15-153
High & Stable Real Growth
15-154
High & Stable Real Growth
Our hope is that policymakers can manage the countrys affairs so that we will stay on
a high and sustainable growth path.
Fluctuations in general business conditions are the primary source of systematic risk,
so stability is important.
Uncertainty about the future make planning more difficult, so less uncertainty makes
everyone better off.
15-155
Financial System Stability
The Fed was founded to stop the financial panics that plagued the U.S. during the
late 19th and early 20th centuries.
Given the recent crisis, we know that financial and economic catastrophes are not
limited to the history books.
Accordingly, financial system stability is an integral part of every modern central
bankers job.
15-156
Financial System Stability
If people lose faith in financial institutions and markets, they will rush to low-risk
alternatives.
Intermediation will stop.
The possibility of a severe disruption in the financial markets is a type of systematic
risk.
Central banks must control this risk.
The value at risk is the important measure here.
This measures the risk of the maximum potential loss.
15-157
Interest-Rate an Exchange-Rate Stability
These goals are secondary to those of low inflation, stable growth, and financial stability.
In the hierarchy, interest-rate stability and exchange-rate stability are means for achieving
the ultimate goal of stabilizing the economy.
They are not ends unto themselves.
15-158
Interest-Rate an Exchange-Rate Stability
15-159
Interest-Rate an Exchange-Rate Stability
The value of a countrys currency affects the cost of imports to domestic consumers
and the cost of exports to foreign buyers.
When the exchange rate is stable, the dollar price of goods is predictable and
planning ahead is easier for everyone.
For emerging market countries, exports and imports are central to the structure of
the economy.
Stable exchange rates are very important.
15-160
Central Bank Objectives:
Summary
15-161
During the crisis, did the Fed sacrifice its monetary policy independence and its objective of
low, stable inflation?
Many Fed actions in the crisis were radical and precedent-setting.
Has the crisis made the Fed a slave of U.S. government policy wishes?
15-162
In a financial crisis, the policy goals may be mutually consistent.
An independent central bank may wish to cooperate with fiscal authorities to
promote financial stability and forestall deflation.
An independent central bank must also be prepared to reverse course when
necessary to keep inflation low.
The difficulty is knowing when to exit.
15-163
Likely the greatest threat to the Fed independence is the popular backlash following the
crisis bailouts of intermediaries like AIG.
If heightened congressional scrutiny leads to political efforts to influence future monetary
policy decisions, confidence in the Feds commitment to low inflation could quickly erode.
15-164
Meeting the Challenge: Creating a Successful Central Bank
15-165
Meeting the Challenge: Creating a Successful Central Bank
15-166
Meeting the Challenge: Creating a Successful Central Bank
15-167
The Need for Independence
The idea of central bank independence, that central banks should be independent of
political pressure, is a new one.
After all, the central bank originated as the government's bank.
15-168
The Need for Independence
15-169
The Need for Independence
15-170
The Need for Independence
The Feds extraordinary actions during the crisis of 2007-2009 led to political
backlash in the U.S. against central bank independence.
The lingering political question is whether Congress will choose to sacrifice the hard-
won gains on the inflation front by weakening central bank independence.
It would be another costly legacy of the financial crisis.
15-171
What drove politicians to give up control
over monetary policy?
15-172
Decision Making by Committee
Monetary policy decisions are made deliberately, after significant amounts of information
are collected and examined.
Crises do occur, requiring someone to be in charge.
During normal operations, however, it is better to rely on a committee than an individual.
15-173
Decision Making by Committee
Pooling the knowledge, experience, and opinions of a group of people reduces the risk that
policy will be dictated by an individuals quirks.
Vesting so much power in one individual also poses a legitimacy problem.
Therefore, monetary policy decisions are made by committee in all major central banks in
the world.
15-174
The Need for Accountability and Transparency
15-175
The Need for Accountability and Transparency
15-176
The Need for Accountability and Transparency
Today every central bank announces its policy actions almost immediately.
However the extent of the statements that accompany the announcement and
the willingness to answer questions vary.
Central bank statements are very different today than they were in the early 1990s.
Secrecy is now understood to damage both the policymakers and the economies
they are trying to manage.
15-177
The Need for Accountability and Transparency
The economy and financial markets should respond to information that everyone
received, not to speculation about what policymakers are doing.
Policy makers need to be as clear as possible.
Transparency can help counter the uncertainties and anxieties that feed liquidity and
deleveraging spirals.
15-178
The Policy Framework, Policy Trade-offs, and Credibility
15-179
The Policy Framework, Policy Trade-offs, and Credibility
The monetary policy framework also clarifies the likely responses when goals conflict
with one another.
All objectives cannot be reached at the same time, and the Fed only has one
instrument.
It is impossible to use a single instrument to achieve a long list of objectives.
The goal of keeping inflation low and stable, then, can be inconsistent with the goal
of avoiding a recession.
15-180
The Policy Framework, Policy Trade-offs, and Credibility
Central bankers face the trade-off between inflation and growth on a daily basis.
In 2008 the FOMC judged that it was more important to cut the policy rate in an effort
to halt the financial contagion that has resulted form the run on Bear Stearns.
Policymakers were forced to choose among competing objectives amid great
uncertainty.
15-181
The Policy Framework, Policy Trade-offs, and Credibility
Because policy goals often conflict, central bankers must make their priorities clear.
The public needs to know:
What policymakers are focusing on and what they are willing to allow to change,
and
The roles that interest-rate and exchange-rate stability play in policy
deliberations.
This limits the discretionary authority of the central bankers, ensuring that they will
do the job with which they have been entrusted.
15-182
The Policy Framework, Policy Trade-offs, and Credibility
Finally, a well designed policy framework helps policy makers establish credibility.
For central bankers to achieve their objectives, everyone must trust them to do what
they say they are going to do.
Expected inflation creates inflation.
Successful monetary policy, then, requires that inflation expectations be kept under
control.
15-183
Central Bank Design:
Summary
15-184
Fitting Everything Together: Central Banks and Fiscal Policy
Before a European country can join the common currency area and adopt the euro it
is supposed to meet a number of conditions.
The countrys annual budget deficit cannot exceed 3% of GDP, and
The governments total debt cannot exceed 60% of GDP.
Failure to maintain these standards can lead to pressure from other member
countries and even to substantial penalties.
15-185
Fitting Everything Together: Central Banks and Fiscal Policy
15-186
Fitting Everything Together: Central Banks and Fiscal Policy
Central bankers, in their effort to stabilize prices and provide the foundation for high
sustainable growth, take a long-term view.
They impose limits on how fast the quantity of money and credit can grow.
In contrast, fiscal policymakers tend to ignore the long-term inflationary effects of
their actions.
They look for ways to spend resources today at the expense of prosperity
tomorrow.
15-187
Fitting Everything Together: Central Banks and Fiscal Policy
15-188
Fitting Everything Together: Central Banks and Fiscal Policy
If officials cant raise taxes and are having trouble borrowing, inflation is the only way out.
While central bankers hate it, inflation is a real temptation to shortsighted fiscal
policymakers.
Inflation is a way for governments to default on a portion of the debt they owe.
15-189
Fitting Everything Together: Central Banks and Fiscal Policy
U.S. Fiscal and monetary policies to combat the crisis of 2007-2009 have led many
observers to worry both about future inflation risks and about renewed financial
instability.
On the fiscal side, in 2009, the federal governments deficit neared 10% of GDP
for the first time since WWII.
On the monetary policy side, the Fed accumulated assets at an unprecedented
pace as it sought to prevent a meltdown of the financial system.
15-190
Fitting Everything Together: Central Banks and Fiscal Policy
15-191
Fitting Everything Together: Central Banks and Fiscal Policy
15-192
Monetary Policy &
Commodity Prices
Jeffrey Frankel
Harvard University & NBER
193
The Choice of Monetary Regimes
for Emerging Markets / Developing Countries
194
I. How are EMs & Developing Countries different from Advanced Economies?
2. Supply shocks.
195
How are EMs different from Advanced Economies? continued
196
How are EMs different from Advanced Economies? continued
1.
197
Trade & Supply Shocks are More Common
in Emerging Markets & Low-Income Countries
IMF SPRD & World Bank PREM, 2011, Managing Volatility in Low-Income Countries: 198
The Role and Potential for Contingent Financial Instruments, approved by R.Moghadam & O.Canuto
II. What is the desirable exchange rate regime?
Advantages of fixing.
Advantages of floating.
Which dominate?
Optimum Currency Area criteria
Other criteria
199
vantages of fixed rates
2) Encourage investment
<= cut currency premium out of interest rates.
1. Monetary independence
2. Automatic adjustment to trade shocks
3. Retain seigniorage
4. Retain Lender of Last Resort ability
5. Avoiding crashes that hit pegged rates.
(This is an advantage especially if origin of speculative attacks
is multiple equilibria, not fundamentals.)
Symmetry of shocks
because then giving up monetary independence is a small loss.
Labor mobility
because then it is possible to adjust to shocks even without ability to expand money, cut interest
rates or devalue.
Fixed rates are better for countries with low financial development because markets are thin:
=> costs of financial shocks outweigh benefits of accommodating real shocks.
Prices of crude oil and other agricultural & mineral commodities spiked in 2008 & 2011.
=> Favorable terms of trade shocks for some (oil producers,
Africa, Latin America, etc.);
=> Unfavorable terms of trade shock for others (oil importers like
Japan, Korea).
Textbook theory says a country where trade shocks dominate should accommodate by floating.
Confirmed empirically:
Developing countries facing terms of trade shocks do better
with flexible exchange rates than fixed exchange rates.
Broda (2004), Edwards & L.Yeyati (2005), Rafiq (2011),
and Cspedes & Velasco (2012).
209
Distribution of EM exchange rate regimes
}
Atish Ghosh, Jonathan
Ostry & Mahvash
Qureshi, 2013, Exchange
Rate Management and Crisis
Susceptibility: A Reassessment,
IMF ARC , Nov..
210
So I reject the Corners Hypothesis.
211
A systematic managed float
Proposed rule: for every 1% of Exchange Market Pressure, the central bank takes
x % as appreciation of the currency
& (1-x) % as an increase in reserves
(relative to the monetary base).
212
Systematic managed floating
J.Frankel & D, Xie, 2010, Estimation of De Facto Flexibility Parameter and Basket Weights in
Evolving Exchange Rate Regimes, AER.
213
Systematic managed float (leaning against the wind):
Kaushik Basu & Aristomene Varoudakis, Policy RWP 6469, World Bank, 2013,
How to Move the Exchange Rate If You Must: The Diverse Practice of Foreign Exchange Intervention by Central Banks and a Proposal for Doing it Better May, p. 14
214
Example: Renewed capital inflows to Asia in 2010
Korea & Singapore took them mostly in the form of reserves,
less-managed floating
more-managed floating
Slope
= 1/x
less-managed floating
216
Source: GS Global ECS Research
III: If the exchange rate is not to be
the anchor for monetary policy, what is?
The need for an alternative anchor led many EMs to Inflation Targeting (IT),
after the currency crises of the late 1990s
pushed them off exchange rate targets.
217
Fashions in international currency policy
since 2008,
analogously to how the currency crashes of the 1990s revealed the drawbacks of
exchange rate targets.
219
If the exchange rate is not to be the monetary anchor, what is? Cont.
220
Nominal GDP Targeting
221
Figure 2: When a Nominal GDP Target
Delivers a Better Outcome than IT
Evidence suggests that the AS curve is indeed sufficiently steep so that NGDPT minimizes quadratic
loss function,
for the cases of Kazakhstan and India:
Nominal GDP Targeting for Middle-Income Countries,
June 2014 for Central Bank Review, of CB R Turkey.
224
.
Mathematical analysis:
Which regime best achieves objectives
of price stability and output stability?
2 2
= a p + (y - )
where p the inflation rate,
y the log of real output,
the preferred level of output;
a the weight assigned to the price stability objective.
225
.
Which regime best achieves objectives of price & output stability? continued
pe = Ep = ( ) b/a.
226
Which regime best achieves objectives of price & output stability? continued
227
Which regime best achieves objectives of price and output stability? continued
228
Estimation of AS curve for Kazakhstan
& other oil exporters
Note: For some countries, estimated slope did not come out signific 229
Estimation of AS curve for India
230
Figure 2:
Estimates When a Nominal GDP Target
Suggest:
Delivers a Better Outcome than IT
Appendix 2:
Are Emerging Markets vulnerable
to a global financial shock?
233
Appendix 1:
Why constrain monetary policy
by a rule?
234
Dynamic inconsistency: The Intuition
Lesson: The authorities cant raise Y anyway,
so they might as well concentrate on price stability at point C.
3. But e adjusts
upward in response
to observed >0.
The LR or Rational
Expectations
equilibrium must
feature e = . e 2. If e would
Result: inflationary stay at 0,
bias >0, despite then to get the
higher Y
failure to raise Y
it would be
above Y .
worth paying the price
4. The country of >0.
would be better off
tying the hands
Y 1. Barro-Gordon
of the central bank. innovation:
Result: Y = Y It can be useful to
(no worse on average think of societys
1st choice as Y= Y
than under discretion), (& =0), even if it
and yet =0. is unattainable.
236
TIME-INCONSISTENCY
OF NON-INFLATIONARY MONETARY POLICY
(Romer 11.53) y y ( ) e
2 2
where the target y y .
1 1
=> ( y ( ) y) a( )
e
2 2
2 2
237
Given discretion, the CB chooses the rate of money growth
and inflation (assuming it can hit it) where
d
( y ( ) y ) a( ) 0
e .
d
Take the mathematical expectation:
( y E ( ) y ) aE ( ) 0.
e
+ Rational expectations: E
e =>
(10.15)
(11.58) E ( y y ) 0 , the inflationary bias.
a
238
ADDRESSING THE TIME-
INCONSISTENCY PROBLEM
How can the CB credibly commit
to a low-inflation monetary policy?
Announcing a policy target = 0 is time-inconsistent,
because a CB with discretion will inflate ex post,
and everyone knows this ex ante.
CB can eliminate inflationary bias
only by establishing non-inflationary credibility,
which requires abandoning the option of discretion.
so public will see the CB cant inflate even if it wants to.
CB ties its hands, as Odysseus did in the Greek myth.
239
Addressing the Time-Inconsistency Problem (continued)
Reputation
Delegation. Rogoff (1985): Appoint a CB with high weight
on low inflation a >> a , and grant it independence.
It will expand at only ( y y )
a
<< inflationary bias of discretion.
240
Appendix 2:
Are Emerging Markets vulnerable
to a global financial shock?
241
3 waves of capital flows to Emerging Markets:
IIF 242
http://www.iif.com/press/press+406.php
The Joseph cycle
243
For emerging markets,
the first phase of 7 years
of plentiful capital flows occurred in 1975-1981,
recycling petrodollars as loans to developing countries.
The turnaround year, 1989, saw the 1st Brady bond issue.
244
Biblical cycle, cont.
245
When implicit volatility is high ( in graph),
capital flows to EMs fall: Risk off (e.g., 2009 GFC)
246
See K.Forbes & F.Warnock (2012), Capital Flow Waves: Surges, Stops, Flight and Retrenchment, J. Int.Ec.
The role of US monetary policy
247
The relationship between the Feds interest rate
and EM capital flows does not always hold.
Powell, Jerome. 2013. Advanced Economy Monetary Policy and Emerging Market Economies.
Speech at the Federal Reserve Bank of San Francisco Asia Economic Policy Conference, November
249 .
http://www.frbsf.org/economic-research/publications/economic-letter/2014/march/federal-reserve-tapering-emerging-markets/
When Ben Bernanke
warned of tapering QE
in May/June 2013,
US interest rates rose,
and EMs fell.
250
Global investors required higher interest rates from EMs after May 2013
251
Global Economics Weekly: 14/07 - The downside risks to EM growth and their market implications,
Which EM countries are hit the hardest?
252
The variables that show up as the strongest predictors of country crises in the past are:
Reserves
Real Exchange Rate
GDP
Credit
Current Account
Money Supply
Budget Balance
Exports or Imports
Inflation
Equity Returns
Real Interest Rate
Debt Profile
Terms of Trade
Political/Legal % of studies where leading indicator was found to be
statistically signficant
Contagion
(total studies = 83, covering 1950s-2009)
Capital Account
External Debt
253
Source: Frankel & Saravelos (2012)
Many EM countries learned lessons from
the crises of the 1990s, which better-prepared them
to withstand the Global Financial Crisis of 2008-09.
254
Foreign exchange reserves are useful
The best predictor of who got hit in the 2008 Global Financial Crisis was reserves
Frankel & Saravelos (2012).
Dominguez & Ito.
This was the same Warning Indicator that also had worked in the most studies of earlier crises.
255
Best and Worst Performing Countries
in Global Financial Crisis of 2008-09-- F&S (2010), Appendix 4
Lithuania
Latvia
Ukraine
Estonia
Macao, China
Russian Federation
Bo tto m 10 Georgia
Mexico
Finland
Turkey
Australia
Poland
Argentina
Sri Lanka
Jordan
Indonesia
To p 10 Egypt, Arab Rep.
Morocco
64 countries in sample India
China
256
E.g.,
B. Eichengreen & P. Gupta (2013) Tapering Talk: The Impact of Expectations of Reduced
Federal Reserve Security Purchases on Emerging Markets, Working Paper.
Jon Hill (2014), Exploring Early Warning Indicators for Financial Crises in 2013 & 2014, HKS,
April.
257
Which EM countries were hit the hardest
by the taper tantrum of May-June 2013?
Or January 2014?
E.g.,
B. Eichengreen and P. Gupta (2013) Tapering Talk: The Impact
of Expectations of Reduced Federal Reserve Security Purchases on Emerging Markets, UCB WP.
Jon Hill (2014)
Exploring Early Warning Indicators for Financial Crises in 2013 & 2014, MPA/ID SYPA, HKS, April.
258
Current account deficits opened up among the Fragile Five after 2005
259
Global Economics Weekly: 14/07 - The downside risks to EM growth and their market implications,
Countries with current account deficits
were hit in June 2013.
The
Fragile
Kristin Forbes, 2014 Five
260
http://www.voxeu.org/article/understanding-emerging-market-turmoil
Countries with high inflation rates were also hit
in the year since May 2013.
A.Klemm, A
.Meier
& S.Sosa,
Taper Tantrum or
IMF, May
Tedium: How U.S.
Interest Rates Affect
Financial Markets in
22, 2014
Emerging Economies
261
Are EMs vulnerable to a new global shock? Conclusion
262
Fiscal and Monetary Policies in Transition Economies
Fiscal policy relates to how the state collects taxes and spends revenues.
Monetary policies are conducted by a central bank, which determines the quantity
of money.
263
I. The macro economy in a socialist country:
The banking system was primitive
Single state bank would serve 2 purposes:
It would passively allocates credit to enterprises in accordance with the plan
It would serves as a system of checking plan performance b/c all movements of material
through the economy has trail in the bank (ruble control)
From the perspective of influencing passive role of money
No financial markets
SOE were funded by the state budget
State control of the foreign trade with both exports and imports control
Currency was not convertible, so the balance of payments was not a function of external mkt
forces and commodity and financial flows.
264
1. Constraints
No managerial and supervisory know-how, inexperience of bank management
No market history of potential lenders
Greater uncertainty regarding the outcome of entrepreneurial projects
Inherited bad loans or debts of SOE
No adequate legal framework and regulation, including a general framework for creditor
protection, such as bankruptcy laws.
Banking reform an the setting-up of capital mkts are generally seen as the most urgent and
related problems. One of the first priorities must be the creation of a CB, usually achieved
by divesting of its other responsibilities and focusing it on functions traditionally reserved
for the CB.
265
2. Development of a banking system
Central bankthe overall general goal of the CB is to ensure macroeconomic stability
Functions of the Central Bank
Acting as a clearing bank for the commercial banks.
Acting as the promulgator and enforcer of regulation to enhance the stability
and efficiency of the financial system
Controlling the stock of money in the economy and hence the interest rate
Monitoring the foreign exchange value of the currency
The main goals of CB are to minimize inflation rate and maximize aggregate output
level. The CB tries to find optimal policy, which will create econ situation that will
stimulate output but without high inflation
After creating the CB priority must be given to developing a commercial and investment
banking system that can be effective in mobilizing savings and allocating investment
capital among potential borrowers.
This process is unlikely to be rapid. Some banks can be created by assuming the
deposit and lending functions of the monobank, holding them for a while in the
public sector, and then privatizing when conditions are appropriate.
266
The biggest banking problem for transition economies is controlling the growth and behavior
of new financial intermediaries that spring up. In Russia, for example, b/w 1989 and 1992
some 1600 bank were created but most did not meet the definition of banks as applied in
the west. Many were created by industrialized enterprises and exist largely to finance their
parent companies by borrowing on the interbank mkt. As such they perform little in the way
of impartially assessing risk or allocating scarce capital resources.
Banking crises in the beginning of transition and had been numerous in less advanced
transition countries, but even in the Czech. The components of such crises are:
Non performing loans (esp. short term) to SOE
Too quick financial liberalization allowing too many new banks on the mkt
Combination of inexperience of bank management, insufficient regulation, and large
opportunities and incentives for fraud, led to dramatic bank failures and deposit
withdrawals
The banking business was plugged by fraud, bribery and negligence, which had emerged
during the financial scandals (Russiafraud, money laundering linked with mafia control,
and by open crime)
The remedy for such crises was sought in privatization
267
The new banking system need:
To support the stabilization program (high interest rates and credit tightening, restrict credit)
To provide finance to the economy
To facilitate privatization and enterprise control
3. Stock markets
Stock markets in transition economies are generally underdeveloped, with low market capitalization
and turnover.
Although most of the transition economies have established formal stock mkts, many of these
mkts are undeveloped. Even the most developed mkts in CEE are smallmkt capitalization
does not exceed $15 billion in the Czech, Hungary, Poland. Among the FSU with the exception
of Russia, mkt capitalization is less then $1 billion.
There is little trading activity with value traded as a share of mkt capitalization averaging less
than 30%.
Poor macro conditions, weak legal protection for minority shareholders and limited
development of institutional investors have constrained their development.
Stock markets are expected to grow but their scale will remain small relative to world stock markets
Large companies are raising funds and listing their shares abroad
Through depositary receipt (to place shares in trust and for trustee to issue depository receipts
that are traded on major financial mkts.
By 1999 there were 12 Russian ADRs (American depository receipts) including 3 with NYSE
listings.
268
III. A Macroeconomic Framework
Macroeconomic balance: I=S+ (T-G) + (M-X)
Iinvestments;
Tgovernment revenues
Ggovernment expenditures
S-private savings
M-imports
X-exports
(T-G)government balance
(M-X)foreign balance
Investment
The state structure through which the investment process took place began to crumble, and it
was not quickly replaced by mkt arrangements
Absence of organizational arrangements to facilitate investments. The emergence of financial
mkts was slow and uneven, hence there was a fall in investments.
The absence of investment was an important reason for initial collapse of output
Investment initially collapses in transition, subsequently recovering somewhat, though not
generally to levels sustained during the command era.
269
Private Savings
During the early years the PS fell from 30% of hhld income to some 15% or less, and later
saving rates increased
Russiainitial collapse, Russian hhlds moved away from making deposits toward simply
holding rubles in cash. Therefore, there was a sharp movement out of rubles toward as
ruble convertibility was introduced.
270
Inflation and Emerging Markets
a) Two sources that affected inflation in transition
During the early years of transition state controlled prices were released. This boosted the
inflation in the transition economies.
Changing fiscal and monetary policy (F&M) for the stabilization in econ; from extremely
simulative F&M to F&M contraction policies to bring down the inflation. Necessary part of econ
reform was monetary and fiscal contraction to bring down the inflation.
200
CIS
150
Baltics and EE
100 Ukraine
Russian Federation
50 Poland
Czech Republic
0
Hungary
-50
1989
1991
1993
1995
1997
1999
2001
271
At the beginning of transition, the stabilization policy needed to bring both F&M variables under
control; the supply of money increased, devaluation of the currency also expanded money supply.
The economies used interest rate policy, direct control of money supply, targeted inflation to bring
down the inflation.
2 phases of inflation
Initial and expected sudden surge in prices
Stabilization phase marked by the decrease in inflation rates, which nevertheless still remain
high
b) Current inflation-4.3% CEE, 13% Southern Europe, 13.7% CIS.
272
IV. The Macroeconomic Agenda and Its Evolution
One of the most controversial aspects of transition has been emergence of new market-type banking
arrangements
Necessary to create a CB, commercial banks, liberalization of interest rates, convertibility of
currency
To create the appropriate legal structure governing the banks operation.
Table 18.1 lists the macroeconomic developments in transition economies. The macroeconomic
agenda has been similar in the various transition economies but has had different outcomes.
273
274
Why Should Emerging Economies Give up National Currencies:
A Case for Institutions Substitution
275
The Debate on Exchange Rate Regimes & Emerging Markets Crises
276
Lessons of Emerging Markets Crises: Sudden Stops & Contagion
277
Why are emerging markets policies less credible?
278
Why are financial frictions more relevant for emerging markets?
(Calvo & Mendoza JIE 2000, Calvo 1999)
279
How do Non-credible Policies and Financial Frictions Create a Sudden Stop?
280
Margin Calls, Trading Costs & Prices in Emerging Markets: An Example LTCM Style
SOE trades equity & debt in global market s.t. margin and short-selling
constraints
Foreign traders incur recurrent & per-trade transactions costs (partial
adjustment rule)
Dynamics of a sudden stop:
Policy uncertainty triggers margin call
SOE fire sells equity to meet call
Foreign traders can only buy at discount
Equilibrium prices fall, triggering new round of margin calls (Fisherian
deflation)
World liquidity shocks carry the virus
281
So, what does this have to do with giving up national currencies?
282
In Emerging Markets, it has a lot to do with giving up national currencies.
283
If it is a great but unrealistic idea, what else can be done?
284
Outline: Vulnerability Among Emerging Markets
Appendices:
EM complaint: Currency wars
The choice of monetary regimes.
285
3 waves of capital flows to Emerging Markets:
IIF 286
http://www.iif.com/press/press+406.php
The Joseph cycle
287
Biblical cycle, cont.
The turnaround year, 1989, saw the 1st Brady bond issue.
288
Biblical cycle, cont.
289
The role of US monetary policy
290
But the relationship between the Feds interest rate
and EM capital flows does not always hold.
2008
GFC
Jay Powell, 2013, Advanced Economy Monetary Policy and Emerging Market Economies.
Speech at the Federal Reserve Bank of San Francisco Asia Economic Policy Conference, Nov.
293
http://www.frbsf.org/economic-research/publications/economic-letter/2014/march/federal-reserve-tapering-emerging-markets/
Taper talk was followed by greater depreciation
among a group of fragile EMs than others.
294
EM stocks fell on fears of higher US interest rates
in both May-June 2013 & January 2014
295
Source: FT
Which EMs are hit the hardest in crises?
E.g.,
Sachs, Tornell, & Velasco (1996) Financial crises in emerging markets: the lessons from 1995, BPEA.
Frankel & Rose (1996) "Currency Crashes in Emerging Markets," JIE.
Kaminsky, Lizondo, & Reinhart (1998) Leading Indicators of Currency Crises," IMF Staff Papers.
Kaminsky & Reinhart (1999) "The twin crises," AER.
296
The variables that showed up as significant predictors
most often in pre-2008 country crises:
Reserves
Real Exchange Rate
GDP
Credit
Current Account
Money Supply
Budget Balance
Exports or Imports
Inflation
Equity Returns
Real Interest Rate
Debt Profile
Terms of Trade
Political/Legal % of studies where leading indicator was found to be
statistically signficant
Contagion
(total studies = 83, covering 1950s-2009)
Capital Account
External Debt Source: Frankel & Saravelos (2012) 297
Many EM countries -- excl. CEE -- learned lessons
from the crises of the 1990s,
which better prepared them to withstand the 2008-09 GFC.
298
China & other EM countries
built up foreign exchange reserves
299
EM borrowers moved from fx-denominated debt to local-currency debt over the last 10 years.
Lithuania
Latvia
Ukraine
Estonia
Macao, China
Russian Federation
Bo tto m 10 Georgia
Mexico
Finland
Turkey
Australia
Poland
Argentina
Sri Lanka
Jordan
Indonesia
To p 10 Egypt, Arab Rep.
Morocco
64 countries in sample India
China
301
302
Other predictors (besides fx reserves)
of who got into trouble in 2008-09 GFC
Current Account
National Savings
Source: Frankel & Saravelos (2012), Are Leading Indicators Useful for Assessing
Country Vulnerability? Evidence from the 2008-09 Global Financial Crisis, J.Int.Ec.
303
The next clean experiment:
Which EM countries were hit the hardest
by the taper tantrum of May-June 2013?
304
Countries with current account deficits
were hit in the spring of 2013.
The
Fragile
Kristin Forbes, 2014
Five
305
http://www.voxeu.org/article/understanding-emerging-market-turmoil
Countries with worse current accounts were hit
by greater currency depreciation after May 2013.
307
Gerald D. Cohen | Jan. 2014, Brookings
http://www.brookings.edu/blogs/up-front/posts/2014/01/29-emerging-markets-taper-tantrum-cohen
Countries with higher inflation rates were hit
by greater currency depreciation after May 2013.
A.Klemm, A.Meie
r & S.Sosa, IMF,
May 2014
309
Countries hit in April-July, 2013, had experienced
real appreciation
and big capital inflows.
in 2013
313
Currency wars
314
Origin of phrase Currency Wars
315
Currency wars
must be another way of saying competitive devaluation
or manipulating exchange ratesto gain an unfair competitive advantage over other members
to quote from
IMF Article IV(1)iii.
316
If US unemployment is high & inflation low,
the Fed will naturally choose
an easy monetary policy (low i).
317
Rajan complains about Fed tightening.
318
US Congressional failure to approve IMF reform
In one respect, at least, China, India & Brazil are right to complain: the lack of proportionate
representation in international agencies.
Congress refuses to pass the bill updating the allocations of IMF quotas among member countries.
Quotas allocations in the IMF determine both monetary contributions of the member states and their
voting power.
The agreement among the IMF members had been to allocate greater shares to big EM countries,
coming primarily at the expense of European countries.
319
320
The Choice of Monetary Regimes
for Emerging Markets
I. How are EMs structurally different
from Advanced Economies?
321
I. How are EMs different
from Advanced Economies?
322
Trade & Supply Shocks are More Common
in Emerging Markets & Low-Income Countries
IMF SPRD & World Bank PREM, 2011, Managing Volatility in Low-Income Countries: 323
The Role and Potential for Contingent Financial Instruments, approved by R.Moghadam & O.Canuto
II. What is the desirable exchange rate regime?
Very small, very open, economies will continue to want to fix their exchange rates, in most cases.
324
Distribution of EM exchange rate regimes
}
Atish Ghosh, Jonathan
Ostry & Mahvash
Qureshi, 2013, Exchange
Rate Management and Crisis
Susceptibility: A Reassessment,
IMF ARC , Nov..
325
So I reject the Corners Hypothesis.
326
Systematic managed floating
Frankel & Xie, 2010, Estimation of De Facto Flexibility Parameter and Basket Weights in
Evolving Exchange Rate Regimes, AER.
327
Systematic managed float (leaning against the wind):
Kaushik Basu & Aristomene Varoudakis, Policy RWP 6469, World Bank, 2013,
How to Move the Exchange Rate If You Must: The Diverse Practice of Foreign Exchange Intervention by Central Banks and a Proposal for Doing it Better May, p. 14
328
Example: Renewed capital inflows to Asia in 2010
Korea & Singapore took them mostly in the form of reserves,
less-managed floating
more-managed floating
Slope
= 1/x
less-managed floating
330
Source: GS Global ECS Research
III: If the exchange rate is not to be
the anchor for monetary policy, what is?
331
Nominal GDP Targeting
332
Figure 2: When a Nominal GDP Target
Delivers a Better Outcome than IT
Some evidence suggests the AS curve is indeed steep enough so that NGDPT minimizes quadratic loss
function:
Nominal GDP Targeting for Middle-Income Countries,
Central Bank Review (CBRT), Sept. 2014.
334
Appendix 3: More indications
of strengthened EM policies after 2001
335
Correlations between Gov.t Spending & GDP
1960-1999
procyclical
Pro-cyclical spending
countercyclical
Counter-
cyclical G always used to be pro-cyclical
spending
for most developing countries.
336
336
Correlations between Government spending & GDP
2000-2009
procyclical
338
IMF
EM countries used post-2003 inflows
EM countries used post-2003 inflows
to build international reserves
to build foreign exchange reserves
M. Dooley, D. Folkerts-Landau
339
& P. Garber,
Actual versus Predicted Incidence of 2008-09 Crisis
Frankel & Saravelos (JIE, 2012)
340
Appendix 4: EM conditions in 2014
341
EMs have had to pay higher interest rates since the taper tantrum of 2013,
but conditions eased a bit after April 2014.
Oct. 2014.
Capital flows recovered after the taper tantrum.
345
IMF WEO, Oct.
2014.
346
Stemming the Tide:
Capital Account Regulations in Developing and Emerging
Countries
347
Motivation and Outline
Outline
Definition, differentiation and economic rationale
Capital controls in the 1980s and 90s: A brief historical account
The 2000s: Changing financial integration and the rebirth of capital controls
The effectiveness of capital controls
Assessing recent capital control measures and looking ahead
348
Definition and Differentiation
Capital controls
Restrictions on cross-border capital movements
Discrimination against non-residents
Macroprudential Regulation
Systemic financial stability
No discrimination according to residence
Market-based
Overlaps
E.g. Reserve requirements; Currency mismatch limits; FX lending restrictions;
Open FX position limits; Core funding ratios
Types of capital controls
Administrative vs. market-based
Permanent vs. temporary
Inflow vs. outflow
Static vs. dynamic
349
The Economic Rationale
New welfare economics of capital controls > Temporary inflow controls to restore efficient
market equilibrium
Capital inflows create externalities through, for example, financial instability and adverse
exchange rate dynamics
Tax on capital inflows to internalize externalities and align private and social cost of
capital mobility
Optimal Pigouvian tax that restores efficient market equilibrium (potentially allowing
even higher financial integration)
Market-based and macroprudential to allow efficient financial integration (new
correctionism)
350
The Economic Rationale
Heterodox economics > permanent, dynamic capital controls to grant policy autonomy and
allow catching up
(Post)-Keynesian: international financial markets characterised by fundamental
uncertainty, herding and animal spirit boom and busts
(Post)-Minskyan: inherent instability of international financial markets
Structural asymmetries of international monetary system: developing country
currencies lower international liquidity premia which requires them to offer higher
interest rates and subjects them to external vulnerability and monetary subordination
>> Capital controls to grant policy autonomy and catch up (reduce structural asymmetries)
Magud and Forbes (2011): Fear of appreciation; Fear of hot money; Fear of large flows;
Monetary policy autonomy
351
A brief historical account: >1980s
Developed countries
Capital controls part and parcel of macroeconomic toolkit
Bretton Woods System (outflow controls)
Liberalization from the 1960s with near completion in 1980s
Developing Countries
Relatively free capital mobility during Gold Standard and Bretton Woods
Capital controls to support industrialization strategies in the 1960s and 1970s (outflow
controls)
First dismantling in South America in the 70s (Chile, Argentina, Uruguay)
First wave of capital flows: syndicated bank loans to sovereigns
Debt Crisis of the 1980s and Lost Decade
352
A brief historical account: 1990s
353
The 2000s and
the Rebirth of Capital Controls
354
Capital Flows to
Developing and Emerging Countries
Initial attempts to deal with capital flow surge with conventional measures (reserve
accumulation and sterilized intervention)
Some timid capital control measures as capital flows further accelerate in 2006/07 (e.g.
Colombia, Brazil, Thailand)
Global financial crisis of 2008 and its aftermath (quantitative easing) further surge in
capital flows
More widespread adoption of capital controls (Brazil, South Korea, Taiwan etc. )
Not all countries resort to capital controls (e.g. Turkey, Chile Mexico)
Apparent U-turn of IMF
356
Average Capital Controls
0.50
0.48
0.46
0.44
0.42
0.40
0.38
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
0.48
0.46
0.44
0.42
0.40
0.38
0.36
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
358
Source: Fernandez et al. 2015
Average restrictions on capital outflows
0.52
0.50
0.48
0.46
0.44
0.42
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
359
Source: Fernandez et al. 2015
The Rebirth of Capital Controls
Ilene Grabel
(1) the rise of increasingly autonomous developing states
(2) the increased assertiveness of their policy makers due to their success in
responding to the current crisis (counter-cyclical policies, innovations in financial
architecture, new activism at the IMF)
(3) a pragmatic adjustment by the IMF to an altered global political economy and
its attempt to maintain legitimacy
(4) the need for capital controls by countries at the extremes
(5) the evolution in the ideas of academic economists and IMF staff
>>> increased economic success and confidence of many developing countries
allowed them not only to break the rules but to tear up the rule book
altogether
360
The Rebirth of Capital Controls
361
Effectiveness of Capital Controls
Klein (2012)
Permanent measures (walls) more effective than temporary ones (gates)
Gallagher (2011): some evidence that capital controls effective in creating space for
independent monetary policy and stemming the rise in exchanger rate and asset prices
362
Assessing Recent Capital Controls
More complex financial integration: new asset classes, investors and objectives
Derivatives
Institutional investors
Exchange rate management
Funding restrictions
Framed as macroprudential regulations
Legitimacy
Necessity
Market-based inflow measures
Domesticated capital controls (targeted, transparent, temporary)
Countercyclical?
Short-term macro-management tool vs. long-term development instrument
Deal with excesses of capital flows rather than facilitate alternative economic model
Ensure general openness to capital flows
Unilateral measures
363
Looking ahead
364
International Macroeconomic Policy: Theory and Evidence from Recent Financial Crises
365
International Macroeconomic Policy
366
International Macroeconomic Policy
367
The nexus between macro news, policy reactions and markets/asset prices
Macro Triangle: macro developments/news, policy reaction, markets and asset prices
Macro developments/news lead to policy reactions
Those policy reactions affect the evolution of the macro variables
Macro news and macro policies affect markets and asset prices (stocks, bonds, currencies,
commodities, credit)
Asset prices react to macro news and policy news, ie unexpected rather than expected
changes.
Asset price changes lead to policy reactions and affect macro variables (through wealth
effects and price effects)
368
Theory and Evidence from Recent Financial Crises
Financial crises have become more frequent and severe in both developed markets (DM)
and emerging markets (EM)
Recent developed markets crises
US housing and sub-prime crisis in 2006-2008
Global Financial Crisis (GFC) of 2008-2009
Sovereign debt crises and economic crisis in the Eurozone (2010-2013): Greece, Ireland,
Portugal, Spain, Italy, Cyprus, Slovenia. Grexit Risk.
(Brexit: a shock rather than a crisis)
Recent emerging market crises:
Mexico (1994), East Asia (1997-98), Russia (1998), Brazil (1999), Turkey and Argentina
(2001)
EM mini-crisis in 2013-15 and Chinas 2015-16 turmoil
369
Nature of Financial Crises
370
Types of financial crises: liquidity versus solvency crises
371
Liquidity versus Solvency Crises
372
Course Structure
Syllabus: http://people.stern.nyu.edu/nroubini/MACRO5.HTM
Textbooks
Reading List: http://pages.stern.nyu.edu/~nroubini/Readingl3.html
Assignments: http://people.stern.nyu.edu/nroubini/ASSIGN01x.HTM
Requirements (assignments, mid-term exam, final exam)
Other online and offline tools for the course
373
Current Global Economic Outlook and Uncertainties (Known Unknowns)
Former U.S. Defense Secretary spoke during the Iraq War of known knowns, known
unknowns and unknown unknowns.
Known unknowns are known risk/uncertainty factors that will materialize in the future in
one way or another
The world economy is characterized today by many known unknowns, for example which
party will win the 2016 U.S. presidential elections?
374
Known Unknowns: US presidential elections
375
Known Unknown: Economy, Fed and exit from ZIRP
376
Known Unknown: Fed Exit from ZIRP (Zero Interest Policy Rate)
377
Known Unknown: U.S. Fall Fiscal Fistfights
378
Macro and market implications of these known unknowns
The resolution of these known unknowns (growth and inflation, Fed policy rate
normalization pace, U.S. fiscal fights in Congress) will affect:
The real economy through demand and confidence (consumer, business) effects
The financial markets and asset prices in the U.S. and globally: bond yields, stock
market, credit spreads, U.S. credit rating, U.S. dollar value, commodities, emerging
markets.
379
Current Known Unknowns
in the Global Economy
380
Current Known Unknowns:
Brexit and EU-disintegration
381
Current Known Unknowns
in the Global Economy: Eurozone
382
Current Known Unknowns
in the Global Economy: Japan
383
Current Known Unknowns
in the Global Economy: China
384
Current Known Unknowns
in the Global Economy: EM
385
Current Known Unknowns
in the World: Geopolitical Risks
386
Current known unknowns: Global Tail Risk Episodes
Three episodes of global tail risk in the last year: summer 2015, Jan-Feb 2016, post-Brexit
turmoil
Will another one occur this year or next?
What will trigger it?
Would the market correction be reversed or lead to a full bear market?
What could reverse the correction: central bank policies or better fundamentals?
387
Current known unknowns: Unconventional monetary policies
In the last decade very unconventional monetary policies in advanced economies that didnt
even exist before (ZIRP, QE, CE, FG, NIRP)
Will these policies continue or phased out?
Are these policies desirable or having unintended consequences and costs?
Will they eventually cause inflation or deflation/lowflation remain more likely?
What will central banks do when the next recession occurs?
Will the baton be passed from monetary to fiscal policy?
388
Current state of the
global economy
New Mediocre (IMF); New Normal (China, PIMCO), Secular Stagnation (Larry Summers),
Great Deleveraging (Ray Dalio), New Abnormal (Roubini)
Lower potential growth in developed markets (DM) and emerging markets (EM)
Actual growth below potential in many DM and EM
Low productivity growth in DM: productivity puzzle in spite of technological innovations
Global economy swinging between periods of Acceleration (positive growth that is
increasing) and Slowdown (positive growth that is slowing down)
389
Causes of
lower potential growth
390
Causes of actual growth
below potential
Great deleveraging high private and public debt and deficits: first US/UK, then
Europe/Eurozone, now emerging markets
Wrong policy mix: too much monetary policy, too little fiscal policy
Asymmetric adjustment between creditors/savers and debtors/borrowers in a way that
creates a global savings glut and a global investment slump
391
Explanations of the low productivity puzzle
392
The global economy after the global financial crisis (GFC)
393
Why U-shaped Recovery in DM?
394
How did we avoid a
Great Depression 2.0?
During the GFC (btw the collapse of Lehman and mid-2009) global economic activity was
falling at a speed similar to the beginning of the Great Depression
The Great Recession of 2008-09 could have ended up into Great Depression 2.0.
What avoided that? Learning the lessons of the Great Depression and avoiding policy
mistakes
Large conventional/unconventional monetary easing
Massive fiscal stimulus for a while
Backstop and bailout of the private sector (financial system, households, corporations)
395
Side effects of the massive policy response during the GFC
The massive monetary/fiscal/bailout response during the GFC was necessary to avoid
another depression
But it has led to lingering problems:
How to exit from ZIRP, QE, CE, FG?
How and how fast to reduce fiscal deficits and debts that may be unsustainable?
How to deal with the moral hazard that bailouts have induced?
396
Do you want to be Keynesian or Austrian following a financial crisis?
Keynesian approach: provide monetary & fiscal stimulus and bailout the private sector as
otherwise the recession can lead to a depression as self-fulfilling panics and runs occur
while private demand is collapsing
Austrian approach (Austerian): front-load the adjustment/reform and restructure balance
sheets and P&Ls. Dont bailout as you postpone financial and operational restructuring and
you cause moral hazard: zombie banks, households, governments
Austrian approach was tried in the 1930s (no monetary/fiscal stimulus and allow banks to
collapse) and led to Great Depression. Liquidate liquidate!
Bernanke learned the lessons of the Great Depression
397
Do you want to be Keynesian or Austrian following a financial crisis?
In the short run you want to be Keynesian as you want to avoid panic, animal spirits, runs
and illiquidity to lead to a collapse of the private sector. Public demand has to substitute for
collapsing private demand. Rescue illiquid but solvent agents.
In the medium-long term you want to be more Austrian and do true economic and financial
restructuring as, otherwise, you can zombify the economy and reduce long term growth
Are problems of illiquidity or insolvency?
398
These debates Keynesian vs Austrian- are still ongoing today
399
Empirical evidence on appropriate policy response
US avoided a double dip recession and is growing at a 2%+ rate (output above pre-crisis
level). Now even Japan is growing better
UK growing more strongly after anemic recovery
EZ had a double dip recession and is now weakly growing (GDP still below pre-crisis level)
What explains this relative performance?
Relative monetary easing stronger in US/Japan/UK
Front load or back load of fiscal consolidation
Backstopping the financial system and recapitalizing the banks early on to avoid a severe
credit crunch
400
Recent Reversal of
DM vs EM Growth Fortunes
401
Why growth is recovering in DM?
Deleveraging of private and public sector balance sheets has been ongoing for 7 years.
New rounds of unconventional monetary policies in the U.S., Japan (QE and FG) and even in
the EZ and UK (QE, CE and FG)
Bailouts of banks and sovereigns in the EZ avoided a worse crisis and EZ break-up.
Global tail risks are now lower
The massive monetary stimulus has led to asset reflation (equity, housing, lower bond
yields) that boosts confidence and increases demand
402
Why DM recovery will remain uneven?
403
DM outlook
404
Why slowdown of Growth in EM
and Financial Pressures?
Strong growth in EM in the last decade (2003-2013) was due to structural factors and
cyclical/luck ones
Structural:
1st generation structural reforms (trade liberalization, openness to FDI, privatizations,
opening of the economy)
Sounder monetary and fiscal policy and stronger balance sheets after the EM crises of
the 1990s
Cyclical:
China boom (10-11% growth)
Commodity super-cycle (partly because of China)
Super-easy monetary policies in DM after 2009. Zero rates and wall liquidity searching
for yield
405
Why slowdown of Growth in EM
and Financial Pressures?
406
Which EM will suffer the most?
Some EM have stronger macro, financial and policy fundamentals and some have weaker
ones
Weaker ones include countries with large current account deficits, large fiscal deficits, falling
growth, commodity exporters, rising inflation, socio-political protest and upcoming elections
Weaker group includes the Fragile Five: India, Indonesia, Brazil, Turkey, South Africa
Other fragile EM include China, Russia, Argentina, Venezuela, Malaysia, Ukraine
407
Will some EM experience a severe financial crisis?
Compared to the past even the weaker EM (fragile five) have some positives:
Flexible exchange rates rather than fixed ones that could collapse
A war chest of forex reserves to avoid liquidity runs on banks, currencies and
governments
Less currency mismatches and liability dollarization
Lower private/public/external deficits and debts: less solvency risk
Better regulated banks and financial systems
408
Will some EM experience a severe financial crisis?
409
Fragile EM in 2014-15
Jan-Feb 2014 EM pressures: Argentina, Turkey, Thailand politics and China scare
Market pressure abated after February 2014 as many fragile EM tightened monetary, credit
and fiscal policy. Markets rally that year.
But macro and structural adjustment was still partial in fragile EM
New bout of severe EM volatility in EM in spring-summer 2015 as China hard landing risk
rose and led to a fall in commodity prices while the Fed was signaling exit from ZIRP
410
Medium term optimism for EM in spite of short run pressures
411
Will the DM recovery soon lift
the growth in EM?
Optimistic viewpoint: the strong recovery of DM growth will soon lift via trade channels
the growth rate of EM (recoupling)
Three reasons to be partially skeptic:
The recovery of most DM will be somewhat anemic (EZ, Japan, US, UK).
EM have some fundamental macro and structural problems that will take time to
resolve. So DM and EM may decouple
If the DM recovery will be stronger the Fed may exit zero rates faster and that will hurt
the weaker EM while benefitting the stronger ones via trade links
412
US growth is improving
in 2016 after a rocky start
413
Causes of US growth acceleration
More advanced deleveraging, easy Fed policies, positive asset reflation, less global tail risks
Shale gas and oil revolution
Re-shoring of energy intensive manufacturing
Stronger labor market with job creation
Strong P&L and balance sheet of corporate sector and banks
414
Some lingering US risks
415
The Macro-Pru Debate
After GFC central banks care both about economic stability (strong growth with low
inflation) and financial stability
Easy money justified by slow recovery has led to asset reflation that can end up in asset
bubbles
Fed view: two targets and two instruments: monetary policy for economic stability and
macro pru for financial stability/avoiding bubbles
But macro-pru may not work as untested and hasnt worked in the past: only instrument
that enters in all cracks of the financial system is the interest rate instrument
If macro pru doesnt work: damn if you do and damn if you dont as:
Slow exit given weak recovery could cause the mother of all boom/bubbles that will
eventually go into a bust/crush
OR:
If macro pru doesnt work and monetary policy is then used to prick the bubble risk of a
bond market rout and hard landing of the real economy
416
Eurozone outlook: less tail risks but fundamental problems unresolved
The recovery of the EZ after the GFC was weaker than in the US given weaker policy stimulus
The EZ relapsed in a double dip recession in 2011-2013
The periphery of the EZ entered a severe financial crisis with serious sovereign risks. Seven
countries in trouble and five bailed out (Greece, Ireland, Portugal, Spain, Cyprus)
Problems were initially in the private sector in Spain and Ireland; in the public sector in
Greece, Portugal and Italy
Doom loop between the EZ banks and the sovereigns
At the peak of the crisis in summer of 2012 risk of Grexit, EZ break-up, loss of market access
by Italy and Spain
417
EZ tail risks are lower today
418
Some Positives in the EZ Today
419
The Negatives in the EZ
420
The Negatives in the EZ
421
Draghinomics looks like Abenomics
Draghi: Slow growth depends also on aggregate demand not only on supply constraints
(slow reforms)
Three arrows: QE and CE; fiscal stimulus in short run with continued medium term
consolidation; structural reforms
ECB does its share: QE, NIRP and CE
The fiscal stance will remain too restrictive
Asymmetric adjustment of EZ continues
Structural reforms are too slow
422
Abenomics is only partially working in Japan but many risks remain
423
China: Hard landing or soft landing?
424
Major Es in the global economy:
The 2010-2016 period
Economy
Energy and oil prices
Exchange rates and external imbalances
Euro/Eurozone/ECB
Emerging Markets
East as Middle East
East as East Asia
Earnings/Equity markets
425
Economy (global) during the Global Financial Crisis (GFC)
The US and the global economy experienced in 2008-2009 their worst recession in decades
The housing and mortgage bust led to an economy wide recession in the US as there were
spillovers of the housing recession to other sectors of the economy (autos, manufacturing,
consumer durables)
The liquidity and credit crunch that started in the sub-prime mortgage market spread to all
credit and financial markets as this was not just a sub-prime problem: sub-prime, near prime
and prime mortgages, commercial real estate mortgages, credit cards, auto loans, student
loans, leveraged loans
Also the US consumers (consumption is 70% of aggregate demand) were shopped-out,
saving-less and debt-burdened
426
Economy (in the GFC)
This was both a liquidity crunch and a credit crunch the driven by serious solvency problems
given over-leverage of households, financial institutions and parts of the corporate sector
The myth that the rest of the world could decouple from the US recession was shattered in
2008: there was massive re-coupling first in financial markets and then in the real economy.
Recession in most advanced economies (US, Eurozone, Japan); recession or massive growth
slowdown in emerging market economies)
The Great Recession of 2008-09 bottomed out in late 2009 when most economies started to
recover. But the recovery in DM since then was been anemic, sub-par, below trend, a U-
shaped recovery. Stronger in 2016 as deleveraging more advanced?
427
Causes of the housing/credit bubble and bust/crisis
Easy monetary policy (the Fed tightened too little too late)
Lax supervision and regulation of the financial system
Excessive risk taking and leverage of the financial sector given distorted incentives
Global current account imbalances and global savings glut
Irrational exuberance and animal spirits leading to bubbles
Government subsidization of housing (tax benefits, role of Fannie and Freddie, Community
Reinvestment Act)
Distorted incentives of rating agencies
428
Energy
US/global recessions have been associated with oil price spikes (1973-74, 1979-80, 1990-91,
2000-2001).
In 2008 oil prices spiked again. This increase in oil prices was not driven by economic
fundamentals but, in part, by speculation
The high oil prices were one of the factors that triggered the global recession as they
represented a negative terms of trade and real disposable income shock for oil importing
economies (US, Eurozone, Japan, China, etc.)
Once the global recession emerged oil, energy, commodity prices collapsed (oil down to $30).
Later oil prices recovered and till 2013 they were around $100 as the global recovered.
But in 2014-15 oil prices crashed given supply shock (shale revolution) and weak demand
Impact of low oil on growth and inflation
429
Exchange rates and External imbalances
The strength of the U.S. in the 1990s relative to Euro, Yen and other currencies led to a large
a growing current account deficit in the US as the US lost competitiveness
After 2000, the US current account deficit worsened further as the fiscal deficits
mushroomed (twin deficits) and as the private savings rate sank close to zero
This led to the debate on whether this current account deficit was sustainable or was going
to lead to a crash in the value of the US dollar and/or a spike in US interest rates (dollar hard
landing)?
The dollar started to decline in 2002-2004, especially relative to the Euro, but then it sharply
appreciated again in 2005 as interest rates and real growth differentials favored the $
relative to the euro and the yen.
But the dollar resumed its fall in 2006-07 when the US had a growth slump, a financial crisis,
and the Fed cut the Fed Funds rate starting in the fall of 2007
430
Exchanges rates and External imbalances
The global current account imbalances were one of the causes of the global financial crisis
The dollar started to appreciate during the financial crisis of 2008 as panicked investors were
seeking the safety of dollar assets. When risk is off the dollar goes up
The US trade deficit also started to shrink as the fall in consumption led to a fall in imports.
But was this improvement mostly cyclical or structural? Is shale gas a game changer for the
U.S. external balance?
The risk of a dollar crash if foreign investors who financed the US twin deficit & became
concerned about the sustainability of such deficits is now lower as the US twin deficits
have been shrinking
The dollar rose rapidly since mid 2014 as growth recovered and the Fed is expected to exit
ZIRP. Impact on growth and inflation
431
Europe/Euro/ECB (2000-2012)
Growth was sluggish in Europe in the 1990s relative to the U.S. given structural impediments
to growth
Recovery of European growth after 2005
The Euro showed significant weakness relative to the US dollar until mid 2002 as the
Eurozone growth was weaker than US growth.
The Euro then sharply appreciated until the end of 2004 (by about 40%), and again in 2006-
07 (after a brief dollar rally in 2005)
During 2008 not only Europe did not decouple from the US crisis but the recession in the
Eurozone was more severe than in the US
This was in part due to the fact that the policy easing in Europe (monetary and fiscal) was
not as aggressive as in the US
432
Europe/Euro/ECB
Fiscal stimulus in Eurozone was weaker because many of the member countries start from
large fiscal deficits, large stocks of public debt and banks that are too big to fail and too big
to be saved
ECB easing during and after the GFC was weaker than the one of the Fed as the ECB has a
single mandate of price stability.
The recovery of growth in the EZ was even more anemic than the one of the US given less
easy monetary policy, early fiscal tightening and unresolved bank problems
Sovereign debt problems in the EZ and the EZ crisis
Potential growth for the Eurozone is low 0% to 1.5% in the periphery - and possibly falling
because of structural rigidities. EZ at risk of near deflation now.
What are the prospects for structural reforms in Europe?
Will QE prevent deflation and restore stronger growth?
433
Emerging market economies (2000-2013)
Emerging market (EM) economies experienced many economic and financial crises in the
1994-2002 period
2001 was a dismal year for emerging market (EM) economies. The slowdown of growth in
US and G7, the tech bust and the reduction of flows of capital to emerging markets led to a
sharp slowdown of growth in many emerging markets.
Outright currency and financial crises emerged in Turkey (February 2001) and Argentina
(December 2001). In 2002, severe pressures mounted in Uruguay and Brazil; Uruguay
experienced a severe financial crisis in 2002; Brazil barely escaped a financial crisis as
elections loomed in late 2002 but then it recovered after Lula followed moderate policies.
434
Emerging market economies
Emerging market (EM) economies growth recovered sharply in 2004, especially in Asia but
also in Latin America. Important role of macro and financial reforms after the EM crises in
this growth recovery
2004-2007 were excellent years for EMs as global conditions were ideal: global growth was
high, global interest rates were low, commodity prices were high and global investors risk
aversion low (search for yield).
The financial crisis to a massive re-coupling financial and real - of emerging markets with
advanced economies: many emerging markets entered a recession and others had a massive
growth slowdown.
Financial and economic crises in Emerging Europe
The recovery of growth in some emerging markets China, India, some other parts of Asia,
Brazil and parts of Latin America was earlier and faster than advanced economies as their
macro and financial fundamentals are robust. A V-shaped recovery
But in 2013-15 many EM faced slowdown. Will Fed exit lead to another tantrum? Will
Chinas slowdown hurt a lot the EM?
435
East as in Middle East
436
East as in East Asia
China experienced rapid economic growth and overheating in the 2003-2008 period
The GFC led to a massive growth slowdown in China in the fall of 2008. But the aggressive policy
reaction of China led to a robust growth recovery. But China risks now a hard/rough landing
unless it changes its growth model fast enough
Indias dynamism in IT contributed to high growth in last decade. But India now faces severe
fiscal problems and need for major structural reforms. Growth slowed down sharply after 2012.
Will the new Modi government accelerate reforms to boost growth?
East Asia growth strongly depends on China and the US. A number of Asian EM may be at risk
given China
Japans recession in 2008-09 was very severe and the recovery anemic. Will now Abenomics
work or not?
Asia geopolitical tensions: Will China rise peacefully?
437
Earnings/Equity markets (2004-2009)
Equity markets in the US and globally did well in the 2006-2007 given high global economic
growth
High earnings growth, much improved corporate balance sheets, easy monetary conditions
supported equities
Profits sharply increased as a share of GDP
But during the recent global financial crisis US and global equities sharply fell (by over 50%
btw the fall of 2007 and March 2009) with a bear market that experienced a number of bear
market rallies.
Since March 2009 a massive rally in U.S. and global equity markets (over 150%). Is it
excessive and at risk of a significant correction or bound to rise further?
Some disconnect between slow recovery of the real economies and rapid rise in equity
prices.
438
Earnings/Equity markets
(2010-2016)
439
Linkages between the U.S. and the rest of the world occur via various channels
Trade
Capital flows and FDI (Europe, Japan, Emerging markets)
Value of the US dollar
US monetary and fiscal policy
Global stock markets and financial links
Developments in oil and commodity markets
Political shocks and risks
Global investors and corporate confidence
440
Fed policy: 2000-2016
The Fed reduced the Fed Funds rates 11 times in 2001, by 475pbs to a rate of 1.75% as the
economy entered a recession.
Faltering in the US recovery in the fall of 2002 led the Fed to cut the Fed Funds again, down
to 1.25% in November 2002 and down to 1% in June 2003 as a jobless recovery emerged
during the war with Iraq.
In 2004, as growth of output and jobs picked up and inflation started to increase, the Fed
started to increase the Fed Funds rate in 17 consecutive steps bringing it to 5.25% by June
2006 and then pausing in August 2006.
The risk of a US hard landing and the market turmoil in the summer of 2007 led the Fed to
cut rates starting in the fall of 2007 from 5.25% to effective 0% in 2008
Massive quantitative easing in 2008-13 during/after the financial crisis: unconventional
monetary policy. QE tapering started in Dec 2013. Likely ZIRP exit in 2015
441
US fiscal policy since 2008
442
Global current account imbalances
Are the global current account imbalances (still large deficit in the US and fragile EM, large
surpluses in Europe, China and some emerging market economies) sustainable over time?
Is the US current account deficit and external debt accumulation sustainable? It is shrinking
but maybe too slowly?
Will the adjustment of global imbalances be orderly or disorderly?
Is the global current account adjustment to asymmetric as deficit countries need to retrench
while surplus countries arent reducing their surpluses? Is this deflationary for the world?
How will the major currencies ($, Yen and Euro) perform? Will the dollar weaken or
strengthen over time?
Is the recent 2104 dollar strength sustainable and how will it affect the US external balance,
growth and inflation?
Is the risk of a hard landing of the US dollar - especially if the foreign creditors of the US get
tired of financing the US twin fiscal and current account deficits reduced as the twin
deficits are now smaller?
Will EM with external deficit experience a sudden stop/crisis?
443
Global deflation or inflation?
and commodity prices
Until 2007 and early 2008 there was concern about global inflation as global growth was
robust, emerging market economies were overheating and experiencing double digit
inflation (30 plus countries) and as commodity prices were rising
But once the US recession became global in the second half of 2008 serious deflationary
pressures emerged in the global economy because of slack in goods markets, slack in labor
markets and sharply falling commodity prices
By spring of 2009 economies experiencing actual deflations included US, Eurozone, Japan,
China and a number of other advanced economies and emerging markets
Will inflation return as the global economic recovery may accelerate in 2016 and beyond?
Or are disinflationary forces stronger?
Will inflation surprise to the upside in the US and cause the Fed to be behind the curve
regarding exit from zero rates?
Should we worry more about inflation or about deflation and over which time horizon
should we worry more about one or the other?
Is the commodity super-cycle really over and why?
444
Some of the cutting edge issues (and jargon terminology used) in international macro policy
debates
445
Some of the cutting edge issues in
international macro policy debates
446
Some of the cutting edge issues in
international macro policy debates
447
Some of the cutting edge issues in
international macro policy debates
448
Sources of International
Macroeconomic Interdependence
among Economies
Trade links:
Income effects on imports and exports of goods and services
Direct and indirect trade links
Exchange rate effects on trade
449
Financial channels of interdependence
450
Interdependence channels via
common shocks and FDI/MNCs
451
Interdependence via Policy Links
452
Many Financial Crises in Emerging Markets and G7 Economies in the last two decades
453
Crises and financial stresses in Advanced/G7 Economies
454
Crises and financial stresses in Advanced/G7 Economies
Bursting of the US asset price bubble in equity markets in 2000-2002; IT and dot.com crash.
US corporate and accounting scandals in 2002-2003 (Enron, Sarbox legislation, etc.)
GM-Ford downgrade in 2005 and turmoil in credit derivatives markets
Equity market turmoil in the spring of 2006 during the inflation scare
Housing bust and sub-prime crisis in the US (2006-2008)
US and global financial markets turmoil and volatility starting in the summer of 2007
Global financial crisis and recession of 2008-2009
Eurozone crisis of 2010-2013
Risk of new asset/credit bubbles in 2014-16 & beyond?
455
Major macro and financial events of the last 30 years: Advanced Economies
1987: Greenspan becomes chairman of the Fed. Stock market crash in the US in 1987.
S&L (Saving and Loans) financial crisis in the late 1980s; evidence of a credit crunch in the
US.
US and global recession in 1990-91 during the Gulf War.
Persistent stagnation of Japanese economy in the 1990s (4 recessions in the 1990s decade)
after the bursting of the 1980s asset bubble
Currency crisis in the European Monetary System in1992-93
European Monetary Union (1999 introduction of Euro) and mediocre economic/growth
performance of Europe in the 1990s
Large swings in the value of G3 currencies ($, Yen, Euro)
Global financial crisis in 1998 following Russian crisis and LTCM collapse
New Economy, internet and technology boom: the U.S. boom years (1995-2000): high
growth, low inflation, high productivity growth, low unemployment rate, boom in equity
markets, budget surpluses, strong dollar, large current account deficits.
Bust of the IT bubble in 2000-2001; sharp fall of investment leading to economic slowdown
in the US.
456
Major macro and financial events of the last 30 years: Advanced Economies
457
Major macro and financial events of the last 30 years: Emerging markets
Latin American debt crisis (in the 1980s) and its solution (Brady Bonds) in the late 1980s and
early 1990s
Large capital flows to emerging markets in the 1990-95 period.
Transition to a market economy in Central and East European countries.
Mexican currency crisis in 1994-95
Asian currency and financial crisis (Thailand, Indonesia, Korea, Malaysia) in 1997-98
Russian financial and currency crisis (8/98) and its contagion to emerging markets and
advanced economies financial markets (LTCM)
Currency crisis in Brazil in 1/99
Financial turmoil and IMF rescue packages in Argentina and Turkey in November-December
2000
Sovereign debt restructurings after partial/full default in Ecuador, Russia, Ukraine and
Pakistan in 2000-2001
Turkish currency and financial crisis in February 2001
458
Major macro and financial events of the last 30 years: Emerging markets
459
Ulysses and the Sirens:
Political and Technical Rationality in Latin America
Javier Santiso
460
A POLICY-ORIENTATED RESEARCH PROJECT
Research Project:
Policy-issues:
461
TECHNOPOLS AS INSTITUTIONAL MASTS
Albert Hirschman
462
1. Technopols in Latin America: Cognitive Mapping of Institutional Masts
463
A COGNITIVE MAPPING OF
464
TECHNOPOLS IN EMERGING DEMOCRACIES
1. What is the cognitive map in Latin America for applied knowledge in economic policies?
There are no in-depth studies that measure the institutional density of production centers
and the diffusion of applied knowledge in economic policies.
These centers operate as technopols, i.e. institutions that articulate proposals of acceptable
economic policies which are both adoptable by and adaptable to their respective
democracies.
A strong institutional presence of this kind does not guarantee an adequate articulation
between technical and political rationality. Some examples exist where a high cognitive
institutional presence has coincided with an overflow of economic policies due to political (i)
rationality (or formulated in weberian terms an overflow of the ethics of conviction).
465
TECHNOPOLS AS TRESPASSERS
This is a necessary condition (although not sufficient) for an adequate articulation between
technical rationality and political rationality.
If the key institutions for development are those that promote governance accountability
and provide information over government actions authorizing citizens to sanction behavior
that limits the capturing of rent (Benhabib and Przeworski, 2004), technopols carry out a
central role.
The technopols operate in this sense as traders or, to use Hirschman terminology,
trespassers of knowledge between technical rationality and the political rationality.
This aspect is important. Many of the reformist impulses that are merely adopted from
other national or regional contexts without being adapted, fail because of the lack of the
trespassing process. Hence the Przeworski description, the cemetery of institutional
reforms must be enormous.
466
MAPPING TECHNOPOLS
The first aim of this study will be to establish the cognitive map in applied knowledge in
economic policies in the different countries of the region.
The technopols can be national or foreign; public or private. For this mapping we will take into
account institutions of knowledge such as analysis units of international organizations or
government agencies, private consultants or research departments of banks; academic
research centers.
The study will have to incorporate evidence from several countries. Examples will be taken
from the largest possible number of countries, considering in the first place the following
eight: Argentina, Brazil, Chile, Colombia, Mexico, Peru, Uruguay and Venezuela.
The methodology used in this part will be surveys carried out by questionnaires and/or
interviews. For each type of technopols an adapted questionnaire will be used.
467
MAPPING TECHNOPOLS
How many think-tanks and/or university centers contribute to the formulation of policy debate?
What are their human and financial resources.
What is the contribution of the consultants and the research departments to this formulation?
Here we particularly think of the private banks analysis units and the private consultants.
What is the contribution of public entities (Central Bank, Ministry of Economy and or
Planning; public agencies etc.) ?
What is the role of international institutions (BID, CAF, WB, CEPAL, etc.) in the process of
designing economic policies?
468
TYPES OF TECHNOPOLS
Banks
Government
IO Agencies
Policies
Think-
Academics
Tanks
469
BANKS: LATINFINANCE RESEARCH OLYMPICS
The Annual ranking of economists and analysts of the sell-side industry. Every year, Latin
Finance asks institutional investors, the principal consumers of Wall Street research, to
rank the best analysts and economists covering the region.
A tougher regulatory environment and cost cutting at big Wall Street banks have taken
their toll. These banks are under tighter scrutiny from regulators and their internal
compliance departments to avoid even the suspicion that researchers' findings are affected
by the battle for investment banking mandates.
The crackdown has curtailed analysts' direct access to management of the firms they cover
and their ability to talk to the media. The result is less insight coverage and less media
exposure.
470
BANKS: LATINFINANCE RESEARCH OLYMPICS
1 CSFB
2 JP Morgan A total of 63 responses were received
3 Bear Stearns from investors with a combined $33
4 UBS billion under management.
5 SCH
6 Ita
7 Citigroup Votes were weighted in proportion to the
8 Merrill Lynch
9 BCP
assets invested by each firm in Latin
10 Goldman Sachs America.
11 Morgan Stanley
12 Deutsche Bank
13 ING
471
St
a nd
ar
d
C
ha
0
10
20
30
40
50
60
70
80
90
rt
e re
d
W
es
B tL
ea B
rS
G te
ol ar
dm ns
an
Sa
C ch
aj s
a
B M
ar ad
cl rid
ay
s
C
ap
B ita
N l
P
Pa
rib
as
D
re
sd
ne
r
IN
G
H
M SB
er C
BANKS AS TECHNOPOLS: RESEARCH DEPARTMENTS
ril
lL
yn
ch
B
an
co U
B
Vo S
to
D ra
eu nt
ts im
ch
e
B
an
k
Number of Latin American Research Analysts in 2005
Ita
C
SF
JP B
M
or
ga
B n
ra
de
sc
o
SC
H
B
B
VA
472
0
10
20
30
40
50
60
Barclays Capital
Dresdner
Goldman Sachs
Standard Chartered
Caja Madrid
UBS
BNP Paribas
Merrill Lynch
Deutsche Bank
BANKS AS TECHNOPOLS: RESEARCH DEPARTMENTS
ING
Bear Stearns
HSBC
JP Morgan
Banco Votorantim
Ita
Bradesco
Number of Latin American Research Analysts based in Latam in 2005
BBVA
SCH
473
BANKS AS TECHNOPOLS: RESEARCH DEPARTMENTS
100,00%
90,00%
80,00%
70,00%
60,00%
50,00%
40,00%
30,00%
20,00%
10,00%
0,00%
as
FB
BC
VA
G
l
H
n
nk
r id
co
s
tim
ta
ch
er
Ita
ch
IN
ga
SC
rn
tL
rib
re
pi
CS
dn
Ba
BB
es
HS
ad
yn
an
ea
Sa
te
or
es
Ca
Pa
ad
es
lL
M
ar
M
he
St
or
W
an
Dr
Br
ys
P
Ch
ja
ril
t
JP
sc
ar
Vo
BN
dm
Ca
la
er
Be
ut
rd
rc
o
ol
De
da
nc
Ba
Ba
an
St
474
BANKS: WALL STREET IS WATCHING YOU BUT NOT EVERYBODY
80%
70%
60%
50%
40%
30%
20%
10%
0%
Mxico
El Salvador
Uruguay
Per
Chile
Jamaica
Panama
Colombia
Guatemala
Ecuador
Venezuela
Argentina
Brasil
Costa Rica
Rep. Dom.
475
BANKS AS TECHNOPOLS: RESEARCH DEPARTMENTS
14,00
12,00
10,00
8,00
6,00
4,00
2,00
0,00
as
S
FB
BC
VA
l
H
B
n
on
s
nk
r id
s
ta
ch
er
UB
ch
IN
ga
SC
rn
tL
rib
pi
CS
dn
Ba
ly
BB
HS
ad
yn
ea
Sa
or
es
Ca
Ca
Pa
es
lL
M
he
St
W
an
Dr
ys
P
ja
ril
JP
sc
ar
BN
dm
Ca
la
er
Be
ut
rc
M
ol
De
Ba
G
476
PUBLIC ACTORS: GOVERNMENT AND NATIONAL TECHNOPOLS
Samples will also have to include government agencies like Superintendence of AFP in Chile,
the BNDES or IPEA in Brazil, DANE in Colombia, etc.
477
CONGRESS AS TECHNOPOLS: A POLICY ISSUE IN LATIN AMERICA
14 15
12
10 11 11
10 10 10 10
8
8 8
6 7 7 7 7
6 6 6
4 5 5
4 4
2
0
I III V VII IX XI XIII XV XVII XIX XI
478
CONGRESS AS TECHNOPOLS: A POLICY ISSUE IN LATIN AMERICA
Total= 174
479
INTERNATIONAL ORGANIZATIONS AS TECHNOPOLS
480
THINK-TANKS IN LATIN AMERICA
Sample
481
THINK-TANKS IN LATIN AMERICA
482
THINK-TANKS ON LATIN AMERICA OUTSIDE THE REGION
FOCAL (CANADA):
Fosters informed analysis and debate on North and South American social, political and economic
issues.
Engages public and private leaders throughout North and South America in an effort to discuss key
hemispheric problems and opportunities.
483
THINK-TANKS ON LATIN AMERICA OUTSIDE THE REGION
Americas Society:
Based in New York and Washington; founded in 1965 by David Rockefeller; 2 experts on Latin America; http://www.americas-society.org/
Cato Institute:
Hoover Institution:
CIPE
484
THINK-TANKS ON LATIN AMERICA OUTSIDE THE REGION
Canning House:
Based in London; founded in 1943; http://www.canninghouse.com/
485
EXPERTS AND POLITICS IN EMERGING DEMOCRACIES
486
PUBLIC TECHNOPOLS
There are, basically, three government institutions that take economic policy decisions in
Peru: The Ministry of Economy and Finance, the Central Bank (BCR) and the Congress:
487
THE MINISTRY OF ECONOMY AND FINANCE
The function of formulating economic policies, formally lies with the Viceminister
of Economy who makes economic policy proposals, with the support of four of his
Offices (Economic and Social Affairs; International Economy, Competition and
Private Investment; Public Revenue Policies; and, Multiannual Planning of the
Public Sector).
488
THE CENTRAL BANK
Notwithstanding its responsibility in monetary issues the Central Bank also actively
participates in the design of other economic policies (fiscal policy) through its participation
in the aforementioned committees of the Ministry of Economy.
In these policy decisions, the Central Bank usually has considerable influence, as a
consequence of its relatively high institutional development, and the tradition of having a
high technical level army of analysts, statistics, economic models, etc; something that the
Ministry of Economy (and the public sector in general) has not adequately developed.
489
THE CENTRAL BANK
The Economic Studies Department is responsible for the implementation of monetary policy.
It has 120 employees, 80 of them economists.
490
THE CENTRAL BANK ECONOMIC RESEARCH
491
THE CONGRESS: THE LACK OF AN ECONOMIC TECHNOPOL
The Congress
The Congress nas 120 congressmen. They all take part in various Committees where
proposals are discussed. Once these proposals have been approved at Committtee level
they go on to the Congress General Assembly (Pleno del Congreso) for final approval. The
Congress has 24 ordinary committees and congressmen can participate in as many as 3
different committees.
The technical capacity of the Congress is extremely low as its staff do not have the
sufficient preparation and necessary skills to give support to the congressmen in
their economic policy duties.
In 2002, the Congress created the Parlamentary Investigation Center (CIP), with the
aim to bring technical support to the decisions made by congressmen, but in actual
fact, its support has been incipient, because the congressmen recieve support from
private advisors that are paid through the national budget.
492
THE CONGRESS: THE LACK OF AN ECONOMIC TECHNOPOL
The Congress
Each congressman hires, on average, two private advisors, who specialize in different
fields (usually, lawyers, economists and financial experts) who provide expert advice
on legislative duties.
However, bearing in mind the intellectual capacity of the congressmen and the lack of
control over their legislative responsibilities, the employment of these advisors does
not necessarily assure quality in the formulation of economic policies.
Congress has 2.072 internal employees. Of these, 565 are professionals who carry out
executive responsibilities and participate in the various committees.
The technical capacity of the Congress is however, very weak: 4 analysts in total for
Congress. They are appointed by the President of the Congress and, in practice do not give
professional service to congressists.
493
THINK-TANKS IN PERU
Think-Tanks
The three most important in Peru are: Apoyo Macroconsult; Grade and IPE.
494
THINK-TANKS IN PERU: AN INTERNATIONAL COMPARISON
USA
495
THINK-TANKS IN PERU
Apoyo Consulting
Apoyo Consulting is one of the firms belonging to The Apoyo Group. It was
created in 1977, and offers economic, financial and managerial advice to its
clients. It ha approximately 150 firms in its portfolio, including the most
important Peruvian and international firms in Peru.
With a working team of more than 250 , APOYO has had an average income growth of 25
per cent per year since 1977. Its billing reaches US$ 200 per every million dollars of
Peruvian GDP.
It affects economic policy through the advice that it gives to its clients, and the confidential
documents that Apoyo prepares exclusively for them.
They also have monthly meetings, organized for their clients where they discuss important
economic issues and politics. Additionally, its members participate in economics debates in
different forums (seminars, conference, media, etc).
http://www.apoyo.com/english/eco_studies/
496
THINK-TANKS IN PERU
IPE is a private civil association and its aim is to promote the sustainable development
of market economy in Peru, through research, analysis and other activities. Since
1999, IPE gets its funding from member contributions and from its investigations.
IPE is a very active player in policy debate (also through conferences, publications and
public debate in press). During Fujimoris government, most of its members had a direct
participation, exercising different positions in the Ministry of Economy and Finance.
http://www.ipeportal.org/
497
THINK-TANKS IN PERU
Grade
Since it was set up in 1980, GRADE has carried out research in economics,
education, environment, and social topics. The results of their investigations are
known through different resources, such as publications, its web page, press,
amongst others.
GRADE is directed by an Associated Assembly, and most of the principal researchers take
an active part. This Assembly determines the topics and directions for research as well as
defining the development strategies that guarantee GRADEs independence.
GRADE particiates in policy debate at a very high and technical level, and it does not
usually participate in public debate.
http://www.grade.org.pe/
498
ACADEMICS AS TECHNOPOLS
Academics:
There are two universities with research centers contributing to economic publications.
One is the Research Center at Universidad del Pacifico (CIUP), and the other is the Center
of Sociologic, Economic, Politics and Anthropology belonging to the Universidad
Catolica(CISEPA).
Centro Universitario Universidad del Pacfico (CIUP): It was created in 1972 and is financed
with public university funds and specfici financial programs from international and
multilateral organizations.
http://www.up.edu.pe/ciup/
499
INTERNATIONAL ORGANIZATIONS BASED IN PERU
International Organizations
In Peru there are two main international organizations: IDB and CAF. IDB mainly develops
operational labor such as checking the advance of financial programs to the government.
CAF, although it has an economist, makes a marginal contribution to domestic economic
policy debate.
However, the headquarters of IDB and CAF, as well as IMF, could accomplish an important
role by conditioning domestic economic policies (for instance, when IDB finances
programs and asks the government to achieve certain results or when IMF asks the
government to achieve macroeconomic goals).
500
BANS BASED IN PERU
Banks
In the case of private banks, there are three important banking institutions with
economic departments participating in the economic policy debate through their
publications or press commentaries.
These institutions are BBVA Banco Continental, Banco de Credito and Banco Wiese
Sudameris.
501
TECHNICAL RATIONALITY AND POLITICAL RATIONALITY:
502
2. How is political rationality and technical rationality articulated in Latin America?
The question is key to explaining the success and failure of economic policies in Latin
America as Fernando Henrique Cardoso indicated in his speech during the 2004 BID
Annual Congress.
503
We understand the Tecnopols to be knowledge institutions. This means institutions that
facilitate the spread of expert knowledge and its inclusion in the process of elaboration
and implementation of economic policies.
In this sense, their purpose will not only be to make the cognitive map of the specialized
institutions dedicated to the creation and application of knowledge, but also to analyze the
process of the incorporation of this knowledge into the political and administrative
institutions and, above all, in the political process both at executive and legislative power
levels.
504
One of the working hypothesis is that the quality of the economic policies will depend on
the level on which the expert knowledge would be institutionalized in the policy-making-
process (PMP).
This would depend on two main factors: firstly, the existence of a critical mass of
knowledge through the technopols with capacity to generate and spread expert
knowledge.
Secondly, it is essential that this knowledge be filtered in an effective manner in the PMP
by an interaction between political and technical rationality.
505
To analyze this articulation we will use the case study method, centering the analysis on
certain comparative examples.
The first selected case study will be the one concerning the reform of pension funds. This
reform is central and the region has been a precursor in this field.
Above all, we have the necessary support to be able to specify the example.
The second selected case study will be the one on fiscal reform.
506
In this part we will stress the following points:
Identification of the relevant actors and, in particular of the regulatory organisms in each of the
selected countries.
What is the institutional capacity to propose, articulate, and spread reforms in the areas of
pension funds and fiscal reform?
How does it incorporate, process and spread expert knowledge in pension funds and fiscal
matters? Who are the other technopols speakers?
How is the interaction of the organism and its proposals with the executive and legislative powers
articulated?
What is the role of non-national organisms in this process (international organisms, international
banks, foreign academics, etc.)?
507
Ulysses and the Sirens:
Political Rationality and Technical Expertise in
Latin America Emerging Democracies
Javier Santiso
Jeffrey Frankel
509
Fiscal alchemy?
Under post-2008 conditions, we could have been more confident that countercyclical fiscal policy
would have speeded the recovery than countercyclical monetary policy.
510
Fiscal multipliers are relatively high under post-2008 conditions: low output, low inflation, & ZLB.
Martin Feldstein (2009) Rethinking the Role of Fiscal Policy, American Economic Review 99, 2, 556-9: Some of the past problems in
using fiscal policy to stimulate demand may be less of an impediment in the current circumstances.
Econometric studies
Aizenman, Joshua, & Yothin Jinjarik (2012), The Fiscal Stimulus of 2009-10: Trade Openness, Fiscal Space and Exchange Rate
Adjustment, in NBER International Seminar on Macroeconomics 2011, J.Frankel and C.Pissarides, eds. (University of Chicago Press).
Auerbach, Alan, & Yuriy Gorodnichenko (2012a), "Measuring the Output Responses to Fiscal Policy," American Economic
Journal: Economic Policy, 4(2), 1-27, May.
Auerbach, Alan, & Yuriy Gorodnichenko (2012b), "Fiscal Multipliers in Recession and Expansion," in Alberto Alesina and Francesco
Giavazzi (eds.) Fiscal Policy after the Financial Crisis (University of Chicago Press).
Baum, Anja, & Gerritt Koester (2011), The Impact of Fiscal Policy on Economic Activity Over the Business Cycle - Evidence from a
Threshold VAR Analysis Deutsche Bundesbank, Disc. Paper Series 1: Economic Studies, 3.
Baum, Anja, Marcos Poplawski-Ribeiro & Anke Weber (2012), "Fiscal Multipliers and the State of the Economy," IMF Working Paper
12/286.
Blanchard, Olivier, and Daniel Leigh (2013), Growth forecast errors and fiscal multipliers, American Economic Review, 103(3) May.
Fazzari, Steven, James Morley, & Irina Panovska (2012), State-Dependent Effects of Fiscal Policy, Studies in Nonlinear Dynamics &
Econometrics .
Ilzetzki, Ethan, Enrique Mendoza & Carlos Vegh (2013), "How Big (Small?) are Fiscal Multipliers?" Journal of Monetary Economics.
Japan.
Euroland.
Emerging markets.
511
Monetary policy is of course
relatively less powerful at Zero Lower Bound.
512
How had Keynesian fiscal policy been discredited?
Rather:
political failure to pursue stimulus only counter-cyclically.
But that is no excuse for politicians who pursue fiscal policy pro-cyclically,
as was the norm in developing countries before 2000,
and the pattern among some in advanced countries since 2000.
Secular stagnation is not needed to explain recent slow growth; pro-cyclical fiscal policy can do it.
513
Recent cases
1) Japan
2) Euroland
514
(Case 1) Japan
515
Japans monetary easing (QQE)
raised the exchange rate (Yen/$) and stock market
HR dissolved,
Nov. 2012 =>
Abenomics
516
Outlook 2014 - Recovery on a shaky footing, Special , Economic Research Dept., Rabobank November 13, 2013,
But effects on growth (& inflation) were disappointing.
517
Abenomics seemed to boost growth, at first.
But Japan went back into recession in 2014 Q2,
perhaps because of a big increase in the consumption tax.
518
Can Japan address its serious long-term debt problem, while avoiding contraction in the short term?
Proposal:
Replace the immediate discrete rise in the consumption tax
with a pre-announced committed gradual path of increases,
e.g., 0.25% every year until reaching 10%.
Advantages:
If the path is credible, it will preclude a loss of confidence
in the sustainability of Japans debt.
The short-term impact will not be contractionary.
Indeed, it will help generate expectations of inflation.
519
(Case 2) Euroland
Monetary stimulus:
QE, launched Jan. 22, 2015.
Fiscal stimulus:
Those with space should spend.
Structural reform:
esp. labor markets.
520
When the ECB launched QE in 2015,
the euro depreciated immediately
(2% in 3 hours)
521
But fiscal policy was pro-cyclical,
especially in Greece:
expansion in 2000-08, contraction in 2010-14
Source:
IMF, 2011.
I. Diwan,
PED401,
Oct. 2011
522
EU fiscal austerity has been contractionary.
Source:
Paul
Krugman,
May 10, 2012.
Source:
Olivier
Blanchard &
Daniel Leigh,
2014, Learning
about Fiscal
Multipliers
from Growth
Forecast Errors,
fig.1, IMF Economic
Review 62, 179212
Note: Figure plots forecast error for real GDP growth in 2010 and 2011 relative to forecasts made in the spring 524
of 2010 on forecasts of fiscal consolidation for 2010 and 2011 made in spring of year 2010; and regression line.
In 2015 periphery economies remain weak.
525
Source: Jeffrey Anderson and Jessica Stallings, Feb. 13, 2014, Euro Area Periphery: Crisis Eased But Not Over, Institute of International Finance, Chart 3
Fiscal austerity hasnt even achieved the supposed goal of restoring debt sustainability: debt/GDP ratios
continued to rise sharply.
160
France Germany
140
120
Greece Ireland
100
80
Italy Portugal
60
40
Spain
20
.
From Rmi Bourgeot, Fondation Robert Schuman
526
Data source: IMF WEO (October 2014).
(Case 3) Emerging Markets
527
Correlations between Gov.t Spending & GDP
1960-1999
procyclical
Pro-cyclical spending
countercyclical
Counter-
cyclical G always used to be pro-cyclical
spending
for most developing countries.
528
528
Correlations between Government spending & GDP
2000-2009
procyclical
(2) Euroland
531
(1) Japans monetary easing weakened the yen, 2012-13
Takatoshi Ito, Abenomics: Progress, prospects and how the 2020 Tokyo Olympics can help solve Japans debt problem 532
ADB Institute DEC.30, 2013 http://www.asiapathways-adbi.org/2013/12/abenomics-progress-prospects-and-how-the-2020-tokyo-olympics-can-help-solve-japans-debt-problem/
(2)Unemployment in the euro periphery remains high
Source: Jeffrey Anderson and Jessica Stallings, Feb. 13, 2014 , Euro Area Periphery: Crisis Eased But Not Over, Institute of International Finance, Chart 1
533
(3) Emerging Markets
536
Who achieves counter-cyclical fiscal policy?
Countries with good institutions
IQ
537
The quality of institutions varies,
not just across countries, but also across time.
1984-2009
Good institutions;
Countercyclical spending
Frankel, Vgh
& Vuletin,2013. 538
How can countries avoid pro-cyclical fiscal policy?
Rules?
Budget deficit ceilings (SGP) or debt brakes?
Have been tried many times. Usually fail.
Rules for cyclically adjusted budgets?
Countries are more likely to be able to stick with them. But
An under-explored problem:
Over-optimism in official forecasts
of GDP growth rates & budgets.
Frankel & Schreger (2013), "Over-optimistic Official Forecasts
and Fiscal Rules in the Eurozone," Weltwirtschaftliches Archiv.
Frankel (2011), "Over-optimism in Forecasts by Official Budget
Agencies and Its Implications," Oxford Review of Economic Policy.
539
Countries with Balanced Budget Rules
frequently violate them.
BBR: Balanced
Budget Rules
ER: Expenditure
Rules
Compliance
< 50%
541
International Monetary Fund, 2014
US official projections were over-optimistic on average.
544
Most European official forecasts have been over-optimistic.
Figure 1 (F&S, 2013):
Mean 1-year ahead budget forecast errors, European Countries,
Full Sample Period
545
Figure 2 (F&S, 2013):
Mean 2-year ahead budget forecast errors, European Countries,
Full Sample Period
546
The case of Chile
1st rule Governments
must set a budget target,
Frankel (2013), A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by
Chile, in Fiscal Policy and Macroeconomic Performance, edited by Luis Cspedes & Jordi Gali (Central Bank
547
Chiles official forecasts have not been over-optimistic.
548
The ECB to the rescue? Filling the Lacunae in Euro Area
Governance
Gabriel Glckler *
European Central Bank
549
Conceptual Framework
Designing EMU
550
550
Fiscal and financial dominance?
Classic notion of fiscal vs. monetary dominance
(see Sargent and Wallace: 1981, Jeanne: 2012)
Morgan Stanley, Oct 2011: The name of the game: fiscal dominance [] the inability or unwillingness
of governments to rein in debts and deficits becomes a binding constraint on monetary policy and
may well collide with the objective of price stability.
551
Conceptual Framework
Designing EMU
552
552
Designing EMU
Economic basis
Sound money sound finances consensus (McNamara: 1998)
[A single currency] would imply a common monetary policy and require a high degree of
compatibility of economic policies, in particular in the fiscal field; In particular, uncoordinated and
divergent national budgetary policies would undermine monetary stability. (Delors report 1989)
553
Price stability
orientation
of the central bank
ECBs institutional context
Independence
EMU
Monetary
financing
prohibition
No bail-out
clause
554
Designing EMU: positive feedback mechanisms
Monetary Financing
Prohibition
Policy
consequences
SGP internalised
No Bailout Clause
Keep own house
in order' principle
Financial Market
Discipline
135
140
135
120 120
115 115
sovereign risk
105 105
100 100
95 95
556
1998 Q11999 Q12000 Q12001 Q12002 Q12003 Q12004 Q12005 Q12006 Q12007 Q12008 Q12009 Q12010 Q12011 Q1
556
What went wrong (II) ? despite early warnings
Missing elements
Rather than leading to a gradual adaptation of borrowing costs,
market views about the creditworthiness of official borrowers tend
to change abruptly and result in closure of access to market
financing. The constraints imposed by market forces might either be
too slow and weak or too sudden and disruptive. (Delors report)
557
Risk of fiscal dominance 557
What went wrong?: Gaps in the financial governance framework
Two trilemmas:
(1) Financial trilemma (2) The new impossible trinity
558
Conceptual Framework
Designing EMU
559
559
Financial sector debt transferred to public sector
Source: Bloomberg
561
But do markets get it right?
25 150 16 120
GR 10yr Yield IRE 10yr Yield
GR Govt Debt/GDP % IRE Govt Debt/GDP %
140 14
100
20
12
130
80
10
15
120
8 60
110
10 6
40
100
4
5
20
90 2
0 80 0 0
2000-2011 2000-2011
6 100
4 JAP 10yr Yield 240
JAP Govt Debt/GDP %
5 90 3.5
220
3
4 80 200
2.5
3 70 2 180
1.5
2 60 160
1
1 50 140
US 10yr Yield 0.5
US Govt Debt/GDP
0 % 40 0 120
2000-2011 2000-2011
Source: Bloomberg
562
562
Bluntness of debt markets as disciplining devices
Observed payout distribution of debt and equity contracts
http://ineteconomics.org/sites/inet.civicactions.net/files/turner-frankfurt-slides.pdf
563
The fiscal-financial nexus in the euro area
. has been strong since the beginning of 2010
Euro area US
800 300
700
250
600
10Q1 10Q1
10Q2 200 10Q2
500
10Q3 10Q3
Bank CDS
Bank CDS
10Q4 10Q4
400 150
11Q1 11Q1
11Q2 11Q2
300
11Q3 100 11Q3
11Q4 11Q4
200
50
100
0 0
0 100 200 300 400 500 600 700 800 0 50 100 150 200 250 300
Sovereign CDS Sovereign CDS
Source: Thomson Reuters and ECB calculation. Latest observation: 31 Dec 11.
Note: Sovereign CDS euro area average calculated as country CDS weighted by ECB capital key. Banks CDS euro area average is calculated taking the
largest bank of each available country and aggregating using ECB capital key. Each dot represents the pair (av. sovereign CDS, av. bank CDS) at a certain
day in the respective quarter.
564
Market segmentation and the fiscal-financial nexus
565
The risk of re-fragmentation of markets
Cross-border holdings of EU MFIs
Share of cross border collateral used in
(% of total holdings) Eurosystem credit operations
567
The SMP in a comparative context
1400
Fed change in Treasury holdings ($, bn, since QE announcement)
ECB SMP purchases (EUR, bn)
1200
1000
800
600
400
200
0
Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12
568
3 year LTRO as the Big Bertha
569
569
Impact on money markets
Euro area money market spread and volatility CDS for financial and non-financial corporations
Note: The vertical green line denotes the announcement on 8 December 2011 of the two three-year LTROs. The two vertical red lines mark the
allotment of the two LTROs on 21 December 2011 and 29 February 2012 respectively. Source: ECB Monthly Bulletin, march 2012
570
First impact on credit provision
572
The breathing Eurosystem balance sheet
Sources: Bloomberg, BoE, Fed staff calculations, Reuters, Euro MTS, and ECB. Note: market-based inflation expectations (break-even inflation rates).
Latest observation: 30 August 2011.
574
Conceptual Framework
Designing EMU
575
575
2. A robust rescue mechanism
What now?
577
Further governance reform is needed
to operate smoothly and to be more resilient to crises, the Economic and Monetary Union has to
become a true financial union. B Coeure, March 2012
Increasingly, it seems that it is not too bold to consider a European finance ministry, but rather too
bold not to consider creating such an institution J.C. Trichet, October 2011
Financial market union, fiscal union, and political union J. Asmussen, May 2012
578
Toward financial/banking union?
579
Exchange Rate Policy can be characterized
along two dimensions
Currency
Union (Euro)
Commitment
Flexibility
580
With a hard peg, a currencys price is Flexibility
held permanently at a fixed level. For
example, the Chinese Yuan.
.1265 $1 = 7.90Yuan
581
With a soft peg, a currencys price is Flexibility
returned to the predefined parity at
regular intervals (monthly, weekly, etc).
For example, the Algerian Dinar.
e
$1 = 76 Dinar
.012
582
With an adjustable peg, the parity price Flexibility
is adjusted as circumstances warrant
(monthly, weekly, etc). The Bretton
Woods System was an adjustable peg
e
583
With a crawling peg, a currencys price is Flexibility
held permanently at a fixed level, but that
parity level has prescheduled changes
For example, the Mexican Peso followed a
crawling peg in the 1990s
e
584
With a target zone, a currencys Flexibility
price is held permanently
between an upper and lower
bound. The Bretton Woods
system used 2% bands
e
+2%
-2%
585
From 1971 until 1987 the US followed Flexibility
a policy of managed floating (market
based exchange rate with periodic
re-alignments). A pure float would
have no such re-alignments.
USD/JP The Plaza
400.00
Y Accord (1985)
350.00
purposely
300.00
devalued the
250.00
dollar against
200.00
the
TheYen and
150.00
Louvre
Deutschmark
100.00
Accord (1987)by
51%
ended the dollar
50.00
0.00
devaluation
Jan-71 Jan-75 Jan-79 Jan-83 Jan-87 policy of the
plaza accord
586
Policies can also vary by the degree of commitment to the policy
587
Exchange Rate Systems
Pure Float
Dollarization
588
Currency Baskets
Some countries choose to peg to a basket of currencies rather that a
single currency. This basket will have a price equal to a weighted
average of the individual currencies
Latvia: SDR (Euro, JPY, GBP, USD)
Malta: Euro (67%), USD21%), GBP (12%)
Iceland: Euro + 6 other countries
Why peg to a basket?
Baskets of currency should exhibit less volatility that individual
currencies.
The central bank has a wider choice of options for official reserves
589
Costs/Benefits of Fixed Exchange Rates
Main Benefit
Reduces uncertainty with regard to cross border trade in both goods and
assets
Main Cost
Eliminates a countrys ability to use monetary policy for domestic objectives
Full Employment
High Output Growth
Low Inflation
590
Suppose that the US decides to peg to the Euro at a price of $1.30 per Euro
Our ability to maintain the peg depends on our foreign exchange reserves.
Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
E 5,000,000
X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000
591
If we are going to analyze the policy options, we need a structured
framework to proceed.
592
Using PPP and the two Money Market equilibrium conditions, we get the
fundamentals for a currency
M
*
P 1 i M
P* 1 i * *
y y
PPP
P eP *
M Y 1 i
*
e * *
M Y 1 i
This should give us the long run
trend
593
The US is pegging at $1.30/Euro. This explicitly defines a
monetary policy!
M Y 1 i
*
1.30 e * *
M Y 1 i
*
Y 1 i
M 1.30 M *
*
Y 1 i
%M %M * %Y %Y * i* i
Note: All else equal, money growth rates should
be the same.
Suppose that US economic growth is 4% per year while
Europe is 1% per year.
595
Mama knows best!
If Billy jumped off the
Brooklyn Bridge, would
you do it to?
Y 1 i
*
M 1.30 M *
*
Y 1 i
596
You need to choose a currency regime that is compatible in the
long run with your economic fundamentals
Mexicos crawling peg to the US was due to its high inflation rate relative to
the US (high inflation is a result of low economic growth and high money
growth
597
Suppose the Federal Reserve conducts an open market
purchase of $1,000,000 in Treasuries to increase the money
supply, what will the short run impact be?
Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
+ $1,000,000 E 5,000,000
X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000
+ $1,000,000 (T-Bills)
598
The increase in money increases income (this worsens the
trade balance as imports increase) and lowers domestic
interest rates (this worsens the capital account by cutting
offi foreign investment)
LM
BOP 0
IS
y
Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
+ $1,000,000 E 5,000,000
- $1,000,000 X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000
+ $1,000,000 (T-Bills)
- $1,000,000 (Euros)
i
LM
IS
y
If capital mobility is sufficiently high, the increase in
domestic interest rated creates sufficient capital inflow to
finance the trade deficit. The dollar begins to appreciate
i
LM
BOP 0
i
BOP CA KFA
IS
y
Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
+ $1,000,000 E 5,000,000
X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000
+$1,000,000 (Euros)
i BOP 0 LM
i
BOP CA KFA
IS
y
Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
- $1,000,000 E 5,000,000
X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000
-$1,000,000 (Euros)
Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
- $1,000,000
+ $1,000,000 E 5,000,000
X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000
-$1,000,000 (Euros)
+$1,000,000 (T-Bills)
i
LM
Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
- $1,000,000 E 5,000,000
X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000
-$1,000,000 (Euros)
i
LM
i Alternatively, if capital is
mobile enough, the
government could bail
IS out the private companies
y replacing private debt
with public debt
This is riskytotal indebtedness increase!!
Foreign Reserves are dangerously low! What can we do?
Liabilities Assets
$ 6,100,000 (Currency) E 1,000,000 (Euro)
E 1,000,000 (ECB Bonds)
E 2,000,000
X 1.30 $/E
$ 2,600,000
$ 3,500,000 (T-Bills)
$6,100,000
Liabilities Assets
$ 6,100,000 (Currency) E 1,000,000 (Euro)
E 1,000,000 (ECB Bonds)
E 2,000,000
X 1.50 $/E
$ 3,000,000
$ 3,500,000 (T-Bills)
$6,500,000
611
Speculation and Peso Problems
Even a strong currency can become the victim of a speculative attack.
If the market believes that a currency might devalue in the future, they
will sell that countrys currency and assets.
The resulting balance of payments deficit forces the country to devalue
(self fulfilling prophesy)
612
Short Run Management
Currency Pegs work well as long as times are good
A country can maintain an appreciating currency forever
Currency pegs are not terribly successful during tough
times
You cant maintain a depreciating currency forever and
markets know this!
A peg forces you to follow policies that tend to make
economic conditions worse (tight money, balanced
government budgets)
613
Pearls of wisdom from The Karate
Kid
Daniel-san, must talk. Man walk on road. Walk left side, safe. Walk right side,
safe. Walk down middle, sooner or later, get squished just like grape. Same here.
You karate do "yes," or karate do "no." You karate do "guess so," just like grape.
Understand?
614
Committed Floater
Committed Pegger
Uncertain Pegger
615
The Foreign Exchange Market
616
617
Index
70
90
110
130
150
170
190
210
Jan-95
Mar-95
May-95
Jul-95
Sep-95
Nov-95
Jan-96
Mar-96
May-96
Jul-96
Sep-96
Nov-96
Jan-97
Mar-97
May-97
Month
Jul-97
Sep-97
Nov-97
Jan-98
Mar-98
May-98
Jul-98
Sep-98
Nov-98
Jan-99
Mar-99
May-99
Jul-99
Asian Currencies vs. U.S. Dollar
Sep-99
THB/USD
PHP/USD
SGD/USD
TWD/USD
MYR/USD
KRW/USD
618
The Foreign Exchange Market
Definitions:
1. Spot exchange rate
2. Forward exchange rate
3. Appreciation
4. Depreciation
Currency appreciates, countrys goods prices abroad and foreign goods
prices in that country
Exchange rate
D S
Peso/$ Supply of Dollars by
people who want pesos
621
Changes in the Equilibrium Exchange Rate
Supply of Dollars
Exchange rate D S by people who
Peso/$
S want pesos
$ -depreciation
Peso- appreciation
Demand for Dollars by
people who have pesos
623
The Central Bank Can Intervene to Maintain Exchange
Rates
Exchange rate D
$/pound D S
8
1/2/2004
2/2/2004
China
3/2/2004
4/2/2004
5/2/2004
6/2/2004
7/2/2004
8/2/2004
9/2/2004
10/2/2004
11/2/2004
12/2/2004
1/2/2005
2/2/2005
3/2/2005
4/2/2005
5/2/2005
6/2/2005
7/2/2005
8/2/2005
9/2/2005
10/2/2005
11/2/2005
12/2/2005
Chinese Yuan to One U.S. Dollar
1/2/2006
2/2/2006
3/2/2006
4/2/2006
5/2/2006
6/2/2006
7/2/2006
8/2/2006
9/2/2006
10/2/2006
11/2/2006
12/2/2006
1/2/2007
2/2/2007
3/2/2007
625
Currency Crisis
D
Exchange rate
Baht/$ D
52 S
25
70
90
110
130
150
170
190
210
Jan-95
Mar-95
May-95
Jul-95
Sep-95
Nov-95
Jan-96
Mar-96
May-96
Jul-96
Sep-96
Nov-96
Jan-97
Mar-97
May-97
Month
Jul-97
Sep-97
Nov-97
Jan-98
Mar-98
May-98
Jul-98
Sep-98
Nov-98
Jan-99
Mar-99
May-99
Jul-99
Asian Currencies vs. U.S. Dollar
Sep-99
THB/USD
PHP/USD
SGD/USD
TWD/USD
MYR/USD
KRW/USD
627
Law of One Price
Example: American steel $100 per ton, Japanese steel 10,000 yen per ton
If E = 50 yen/$ then prices are:
American Steel Japanese Steel
In U.S. $100 $200
In Japan 5000 yen 10,000 yen
If E = 100 yen/$ then prices are:
American Steel Japanese Steel
In U.S. $100 $100
In Japan 10,000 yen 10,000 yen
Law of one price E = 100 yen/$
628
Purchasing Power Parity (PPP)
629
Big Mac
Index
630
PPP: U.S. and U.K
631
Factors Affecting E in Long Run
633
Expected Returns and Interest Parity
Re for
Francois Al
$ Deposits iD + (Eet+1 Et)/Et iD
Euro Deposits iF iF (Eet+1 Et)/Et
Relative Re iD iF + (Eet+1 Et)/Et iD iF + (Eet+1 Et)/Et
Interest Parity Condition:
634
Deriving RF Curve
636
Shifts in RF
637
Shifts in RD
638
Foreign Exchange I
639
Foreign Exchange II
Appreciationa currency rises in value relative to another
currency
Depreciationa currency falls in value relative to another
currency
When a countrys currency appreciates, the countrys goods
abroad become more expensive and foreign goods in that
country become less expensive and vice versa
Over-the-counter market mainly banks
640
Exchange Rates in the Long Run
Law of one price
Theory of Purchasing Power Parity
Assumes all goods are identical in
both countries
Trade barriers and transportation costs
are low
Many goods and services are not traded across borders
641
Factors that Affect Exchange Rates in the
Long Run
Relative price levels
Trade barriers
Preferences for domestic versus
foreign goods
Productivity
642
Factors that Shift RF and RD
643
Response to i Because e
1. e , Eet+1 , expected
appreciation of F ,
RF shifts out to
right
2. iD , RD shifts to
right
However because e > iD ,
real rate , Eet+1 more than iD
644
Response to Ms
1. Ms , P , Eet+1
expected appreciation
of F , RF shifts
right
2. Ms , iD , RD shifts
left
Go to point 2 and Et
3. In the long run, iD
returns to old level,
RD shifts back, go
to point 3 and get
Exchange Rate
Overshooting 645
Why Exchange Rate Volatility?
646
The Dollar and Interest Rates
647
648
649
650
651
652
Chapter 18
The International Financial System
653
Unsterilized Foreign Exchange Intervention
Federal Reserve System Federal Reserve System
654
Unsterilized Intervention
An unsterilized intervention in which domestic currency is sold to
purchase foreign assets leads to a gain in international reserves, an
increase in
the money supply, and a depreciation
of the domestic currency
655
656
Sterilized
Foreign Exchange Intervention
Federal Reserve System
Assets Liabilities
657
Balance of Payments
658
Monetary Policy Strategy:
The International Experience
659
Role of a Nominal Anchor
660
Exchange-Rate Targeting
Advantages
1. Fixes for internationally traded goods
2. Anchors expectations
3. Automatic rule, avoids time-consistency
4. Easy to understand: sound currency as rallying cry
5. Helps economic integration
6. Successful in reducing
France, UK, Mexico
661
Exchange-Rate Targeting
Disadvantages
1. Loss of independent monetary policy
Problems after German reunification: UK, French monetary policy too
tight
2. Open to speculative attacks
Europe, Sept. 1992; Mexico: 1994; Asia: 1997
3. Successful speculative attack disastrous for emerging market countries
because it leads to financial crisis
4. Weakened accountability: lose exchange-rate signal
662
Currency Boards vs. Dollarization
Currency Boards
1. Domestic currency exchanged at fixed rate for foreign currency
automatically
2. Fixed exchange rate with very strong commitment mechanism and
no discretion
3. Usual disadvantages of fixed exchange rate
4. Still subject to speculative attack
5. Lose ability to have lender of last resort
Dollarization
1. Even stronger commitment mechanism
2. No possibility of speculative attack
3. Usual disadvantages of fixed exchange rtae
4. Lose seignorage
663
Summary: Advantages and Disadvantages of Different
Monetary Policy Strategies
664
Summary: Advantages and Disadvantages of Different
Monetary Policy Strategies
665
Monetary Targeting
Canada
1. Targets M1 till 1982, then abandons it
2. 1988: declining targets, M2 as guide
United Kingdom
1. Targets M3 and later M0
2. Problems of M as monetary indicator
Japan
1. Forecasts M2 + CDs
2. Innovation and deregulation makes less useful as monetary indicator
3. High money growth 1987-1989: bubble economy, then tight money policy
Germany and Switzerland
1. Not monetarist rigid rule
2. Targets using M0 and M3: changes over time
3. Allows growth outside target for 2-3 years, but then reverses overshoots
4. Key elements: flexibility, transparency, and accountability
666
Monetary Targeting
Advantages
1. Able to cope with domestic considerations
2. Signals are immediate
3. Immediate accountability of central bank
Disadvantages
1. Big if: all advantages require reliable relationship between goal and
targeted aggregate
2. In many countries, weak relationship between goal and M-
aggregate
Poor communications device and accountability
667
Inflation Targeting
Five Elements
1. Public announcement of medium-term -target
2. Institutional commitment to price stability
3. Information inclusive strategy
4. Increased transparency through public
communication
5. Increased accountability
668
Inflation
Targeting in
New Zealand,
Canada, and
the UK
669
Inflation Targeting
Advantages
1. Allows focus on domestic considerations
2. Not dependent on reliable relationship between M-aggregate and
inflation
3. Readily understood by public
4. Reduce political pressures for time-consistent policy
5. Focus on transparency and communication
6. Increased accountability of central bank
7. Performance good: and e , and stays low in business cycle
upturn
670
Inflation Targeting
Disadvantages
1. Delayed signalling
2. Too much rigidity
3. Potential for increased output fluctuations
4. Low economic growth
Nominal GDP Targeting
1. Close to inflation targeting with concern about output fluctuations
2. Problem of announcing specific target for real GDP growth
3. Harder for public to understand
671
Monetary Policy
with an Implicit Nominal Anchor
Forward-Looking and Preemptive to Deal With Long Lags
Advantages
1. Focus on domestic considerations
2. Has worked very well in the U.S.
3. If It Aint Broke Why Fix It?
Disadvantages
1. Lack of transparency and accountability
2. Dependence on personalities
3. Inconsistent with democratic principles
672
Comparing Expected Returns I
Dollar assets pay an interest rate of i D and do not have any capital gain
Foreign assets have an interest rate of i F and there is no capital gain
To compare the expected returns on dollar assets and foreign assets
the returns must be converted into the currency unit used
Et the spot exchange rate
Et+1 the exchange rate for the next period
e
Et+1 - Et
the expected rate of appreciation for the dollar
Et
673
Comparing Expected Returns II
Et
The expected return on foreign assets R F is i F
Ete1 Et
Relative R i i
D D F
Et
As the relative expected return on dollar assets increases, foreigners
will want to hold more dollar assets
674
Comparing Expected Returns III
Et
The expected return on the dollar assets R D is i D
e
Et1 Et e
Et1 Et
Relative R i (i
D D F
) i i
D F
Et Et
Which is the same as previously
Relative expected return on dollar assets is the same whether it is
calculated in terms of euros or in terms of dollars
As the relative expected return on dollar assets increases, both foreigners and
domestic residents will want to hold more dollar assets 675
Interest Parity Condition
E e
Et
i i
D F t1
Et
Capital mobility with similar risk and liquidity
the assets are perfect substitutes
The domestic interest rate equals the foreign
interest rate minus the expected appreciation of the domestic currency
Expected returns are the same on both domestic and foreign assets
An equilibrium condition
676
Demand and Supply
for Domestic Assets
Demand
Relative expected return
At lower current values of the dollar (everything else equal), the quantity
demanded of dollar assets is higher
Supply
The amount of bank deposits, bonds,
and equities in the U.S.
Vertical supply curve
677
678
679
680
681
Exchange Rate Overshooting
Monetary Neutrality
In the long run, a one-time percentage rise in the money supply is
matched by the same one-time percentage rise in the price level
The exchange rate falls by more in the short run than in the
long run
Helps to explain why exchange rates exhibit so much volatility
682
683
The Dollar and Interest Rates
While there is a strong correspondence between real interest rates
and the exchange rate, the relationship between nominal interest
rates and exchange rate movements is not nearly as pronounced
684
685
Exchange Rate Regimes
Fixed exchange rate regime
Value of a currency is pegged relative to the value of one other
currency (anchor currency)
Floating exchange rate regime
Value of a currency is allowed to fluctuate against all other currencies
Managed float regime (dirty float)
Attempt to influence exchange rates by buying and selling currencies
686
Past Exchange Rate Regimes
Gold standard
Fixed exchange rates
No control over monetary policy
Influenced heavily by production of gold and
gold discoveries
Bretton Woods System
Fixed exchange rates using U.S. dollar as
reserve currency
International Monetary Fund (IMF)
687
Past Exchange Rate Regimes (contd)
Bretton Woods System (contd)
World Bank
General Agreement on Tariffs and Trade (GATT)
World Trade Organization
688
689
690
How a Fixed Exchange Rate
Regime Works
When the domestic currency is overvalued, the central bank
must purchase domestic currency to keep the exchange rate
fixed, but as a result, it loses international reserves
When the domestic currency is undervalued, the central
bank must sell domestic currency to keep the exchange rate
fixed, but as a result, it gains international reserves
691
How Bretton Woods Worked
692
Managed Float
Hybrid of fixed and flexible
Small daily changes in response to market
Interventions to prevent large fluctuations
Appreciation hurts exporters and employment
Depreciation hurts imports and
stimulates inflation
Special drawing rights as substitute for gold
693
European Monetary System
8 members of EEC fixed exchange rates with one another
and floated against the U.S. dollar
ECU value was tied to a basket of specified amounts of
European currencies
Fluctuated within limits
Led to foreign exchange crises involving speculative attack
694
Capital Controls
Outflows
Promote financial instability by forcing
a devaluation
Controls are seldom effective and may increase capital flight
Lead to corruption
Lose opportunity to improve the economy
Inflows
Lead to a lending boom and excessive risk taking by financial
intermediaries
695
Capital Controls (contd)
Inflows (contd)
Controls may block funds for productions uses
Produce substantial distortion and misallocation
Lead to corruption
Strong case for improving bank regulation
and supervision
696
The IMF: Lender of Last Resort
Emerging market countries with poor central bank credibility and
short-run debt contracts denominated in foreign currencies have
limited ability to engage in this function
May be able to prevent contagion
The safety net may lead to excessive risk taking (moral hazard
problem)
697
How Should the IMF Operate?
May not be tough enough
Austerity programs focus on tight macroeconomic policies rather
than financial reform
Too slow, which worsens crisis and increases costs
698
Direct Effects of the Foreign Exchange Market
on the Money Supply
Intervention in the foreign exchange market affects the monetary
base
U.S. dollar has been a reserve currency: monetary base and money
supply is less affected by foreign exchange market
699
Balance-of-Payments Considerations
700
Exchange Rate Considerations
A contractionary monetary policy will raise the domestic interest rate
and strengthen the currency
An expansionary monetary policy
will lower interest rates and
weaken currency
701
Advantages of
Exchange-Rate Targeting
Contributes to keeping inflation
under control
Automatic rule for conduct of
monetary policy
Simplicity and clarity
702
Disadvantages of
Exchange-Rate Targeting
Cannot respond to domestic shocks and shocks to anchor country are
transmitted
Open to speculative attacks on currency
Weakens the accountability of policymakers as the exchange rate
loses value as signal
703
Exchange-Rate Targeting
for Industrialized Countries
Domestic monetary and political institutions are not conducive to
good policy making
Other important benefits such
as integration
704
Exchange-Rate Targeting
for Emerging Market Countries
Political and monetary institutions
are weak
Stabilization policy of last resort
705
Currency Boards
Solution to lack of transparency and commitment to target
Domestic currency is backed 100% by a foreign currency
Note issuing authority establishes a fixed exchange rate and
stands ready to exchange currency at this rate
Money supply can expand only when foreign currency is
exchanged for domestic currency
706
Currency Boards (contd)
Stronger commitment by central bank
Loss of independent monetary policy
and increased exposure to shock from
anchor country
Loss of ability to create money and act as lender of last
resort
707
Dollarization
Another solution to lack of transparency
and commitment
Adoption of another countrys money
Even stronger commitment mechanism
Completely avoids possibility of speculative attack on
domestic currency
Lost of independent monetary policy
and increased exposure to shocks from
anchor country
708
Dollarization (contd)
Inability to create money and act as lender
of last resort
Loss of seignorage
709
Appendix
Slides after this point will most likely not be covered in class.
However they may contain useful definitions, or further elaborate on
important concepts, particularly materials covered in the text book.
They may contain examples Ive used in the past, or slides I just dont
want to delete as I may use them in the future.
710
Exchange Rate Regimes:
Current Issues in Research & Policy
Jeffrey Frankel
Harpel Chair, Harvard University
IMF Institute
* May 28, 2010 * 711
Topics to be covered
I. Classifying countries by exchange rate regime
De facto vs. de jure
The approaches used to infer de facto regimes
II. Advantages of fixed rates
The trade-promoting effect of currency unions: the case
FLEXIBLE CORNER
INTERMEDIATE REGIMES
FIXED CORNER
basket peg
weights can be either transparent
or secret
crawling peg
pre-announced (e.g., tablita)
indexed (to fix real exchange rate)
adjustable peg
(escape clause, e.g., contingent
on terms of trade or reserve loss)
714
De jure regime de facto
as is by now well-known
[1] Fear of floating -- Calvo & Reinhart (2001, 2002); Reinhart (2000).
[2] The mirage of fixed exchange rates
-- Obstfeld & Rogoff (1995); Klein & Marion (1997).
[3] Parameters kept secret -- Frankel, Schmukler & Servn (2000). 715
Economists have offered de facto
classifications, placing countries
into the true categories
Important examples include Ghosh, Gulde & Wolf (2000),
Reinhart & Rogoff (2004), Shambaugh (2004a), & more to be cited.
Tavlas, Dellas & Stockman (2008) survey the literature.
Unfortunately, these classification schemes
disagree with each other as much as they
disagree with the de jure classification! [1]
=> Something must be wrong.
Sample: 47 countries. From Frankel, ADB, 2004. Table 3, prepared by M. Halac & S.Schmukler.
Shambaugh (2007) finds the same thing:
the de facto classification schemes tend to agree with each
other even less than they agree with the de jure scheme.
Bnassy-Qur et al (2004)
719
=> Something must be wrong.
Difficulty #1:
Attempts to infer statistically a currencys flexibility
from the variability of its exchange rate alone ignore
that some countries experience greater shocks than others.
720
Phrase this 1st approach
in terms of Exchange Market Pressure:
Define
EMP = value of currency + reserves.
EMP represents shocks in currency demand.
Flexibility can be estimated
as the propensity of the central bank to let shocks show up in the price of the currency
(floating) ,
vs. the quantity of the currency (fixed),
or in between (intermediate exchange rate regime).
721
Several things are wrong, continued.
Difficulty #2:
Those papers sometimes impose the choice
of the major currency around which the country
in question defines its value (often the $).
722
Some currencies have basket anchors,
often with some flexibility that can
be captured either by a band (BBC) or
by leaning-against-the-wind intervention.
Most basket peggers keep the weights secret.
They want to preserve a degree of freedom
from prying eyes, whether to pursue
a less de facto flexibility, as China,
or more, as with most others.
723
The 2nd approach in the de facto regime
literature estimates implicit basket weights:
Regress value of local currency
against values of major currencies.
First examples: Frankel (1993) and Frankel & Wei (1994, 95).
More: Bnassy-Qur (1999), Ohno (1999), Frankel, Schmukler, Servn
& Fajnzylber (2001), Bnassy-Qur, Coeur, & Mignon (2004).
Example of China, post 7/05:
Eichengreen (2006), Shah, Zeileis & Patnaik (2005), Yamazaki (2006), Ogawa
(2006), Frankel-Wei (2006, 07), Frankel (2009)
Findings:
RMB still pegged in 2005-06, with 95% weight on $.
Moved away from $ (weight on ) in 2007-08
Returned to $ peg in mid 2008.
724
Implicit basket weights method
-- regress value of local currency against
values of major currencies -- continued .
Null Hypotheses: Close fit => a peg.
Coefficient of 1 on $ => $ peg.
Or significant weights on other currencies
=> basket peg.
But if the test rejects tight basket peg,
what is the Alternative Hypothesis?
725
Several things are wrong, continued.
Inferring de facto weights and inferring de facto flexibility are equally important,
whereas most authors have hitherto done only one or the other.
726
The synthesis technique
A synthesis of the two approaches for statistically
estimating de facto exchange rate regimes:
(1) the technique that we have used in the past to
estimate implicit de facto weights
when the hypothesis is a basket peg with little flexibility. +
(2) the technique used by others to estimate de facto
exchange rate flexibility when the hypothesis is an anchor to
the $, but with variation around that anchor.
727
Several things are wrong, continued.
Difficulty #4:
All these approaches, even the synthesis technique, are
plagued by the problem that many countries frequently
change regimes or (for those with intermediate regimes)
change parameters.
Application to RMB:
Eichengreen (06), Ogawa (06), F & Wei (07)
730
log Ht
= c + w(j) [ logX(j)t ]
= c + w(1) log $ t + w(2) log t
+ w(3) log t + log t
733
Now we introduce Bai-Perron technique
for endogenous estimation
of m possible structural break points
k
log H t ci wi , j log X i , j ,t i EMPt ut
j 1
(6)
t Ti1 1,..., Ti ; T0 0; Tm1 T ; i 1,..., m 1
734
Illustration using 5 currencies
735
Overview of findings
736
Table 1A reports estimation for the Mexican
peso
5 structural breaks
The peso is known as a floater.
To the extent Mexico intervenes to reduce exchange rate
variation, $ is the primary anchor, but some weight on
also appears, starting in 2003.
Aug.2006 - Dec.2008, coefficient on EMP is essentially 0,
surprisingly, suggesting intervention around a $ target.
But in the period starting Dec.2008, the peso once again
moved away from the currency to the north,
as the worst phase of the global liquidity crisis hit and $
appreciated.
737
Table 1A. Identifying Break Points in Mexican Exchange Rate Regime
M1:1999-M7:2009
(1) (2) (3) (4) (5) (6)
740
Bottom line
on classifying exchange rate regimes
741
II. Advantages of fixed rates
1) Encourage trade <= lower exchange risk.
In theory, can hedge risk. But costs of hedging:
missing markets, transactions costs, and risk premia.
743
Why is the estimated effect in euro-land so much smaller
than monetary unions among small developing countries?
744
A natural experiment:
The effects of the French francs conversion to
on bilateral trade of African CFA members.
The long-time link of CFA currencies to the French franc
has clearly always had a political motivation.
So CFA-France trade could not reliably be attributed to currency link,
perhaps even after controlling for common language, former colonial status, etc.
745
745
Results of CFA experiment
746
746
Bottom line on discrepancy in effect
747
Advantages of fixed rates, cont.
2) Encourage investment
<= cut currency premium out of interest rates
3) Provide nominal anchor for monetary policy
Barro-Gordon model of time-consistent inflation-fighting
But which anchor?
Exchange rate target vs.
Alternatives such as Inflation Targeting
[ii] E.g., Rose & van Wincoop (2001); Tenreyro & Barro (2003). Survey: Baldwin (2006)
749
Evidence on currency unions
Currency unions
promote trade/GDP (no evidence of trade-diversion), &
thereby promote LR growth. -- Frankel & Rose, QJE, 2002.
750
III. Advantages of floating rates
1. Monetary independence
2. Automatic adjustment to trade shocks
3. Retain seignorage
4. Retain Lender of Last Resort ability
5. Avoiding crashes that hit pegged rates.
(This is an advantage especially if origin of speculative attacks
is multiple equilibria, not fundamentals.)
751
IV. Which dominate: advantages of fixing or
advantages of floating?
Performance by category is inconclusive.
754
Optimum Currency Area Theory (OCA)
755
Optimum Currency Area criteria for
fixing exchange rate:
756
New popularity in 1990s of
institutionally-fixed corner
currency boards
(e.g., Hong Kong, 1983- ; Lithuania, 1994- ;
Argentina, 1991-2001; Bulgaria, 1997- ;
Estonia 1992- ; Bosnia, 1998- ; )
dollarization
(e.g, Panama, El Salvador, Ecuador)
monetary union
(e.g., EMU, 1999)
1990s criteria for the firm-fix corner
suiting candidates for currency boards or union (e.g. Calvo)
Regarding credibility:
a desperate need to import monetary stability, due to:
- history of hyperinflation,
- absence of credible public institutions,
- location in a dangerous neighborhood, or
- large exposure to nervous international investors
a desire for close integration with a particular neighbor or trading partner
758
V. Three additional considerations, particularly
relevant
to developing countries
759
(i) I would like to add another criterion
to the traditional OCA list:
Cyclically-stabilizing emigrants remittances.
If country S has sent many immigrants to country H,
and their remittances are correlated with the
differential in growth or employment in S versus H,
this strengthens the case for s pegging to H.
Why? It helps stabilize Ss current account even
when S has given up ability to devalue.
But are remittances stabilizing, in the way that private
capital flows promise to be in theory, but fail in practice?
760
Brief literature summary
Theory
Chami et al (2008): remittances are macroeconomically stabilizing.
Martin (1990): steady flow of remittances can undermine the
incentive for governments to create a sound institutional
framework a sort of natural resource curse for remittances.
Bilateral Data
Ratha and Shaw (2005), in the absence of hard bilateral data,
allocate the totals across partners.
Schiopu & Siegfried (2006) created bilateral data set between
some EU countries & neighbors.
Jimnez-Martin, Jorgensen, & Labeaga (2007) estimate bilateral
workers remittance flows from all 27 members of the EU.
Lueth & Ruiz-Arranz (2006, 2008) have largest bilateral data set to
date.
761
Literature review: cyclicality of remittances
Evidence on cyclicality
World Bank: p.c. remittances respond significantly to home country p.c.income.
Clarke & Wallstein (2004) & Yang (2007): receipts rise in response to natural disaster.
Kapur (2003): they go up in response to an economic downturn.
Lake (2006): remittances into Jamaica respond to the US-local income difference
Yang and Choi (2007): they respond to rainfall-induced economic fluctuations.
IMF finds less countercyclicality.
Sayan (2006): 12-developing-country study finds no countercyclicaty.
Lueth & Ruiz-Arranz (2006, 2008): similarly.
OCA
Singer (2008): counter-cyclical remittances are a determinant of the currency decision.
762
Are Bilateral Remittances Countercyclical?
Implications forCurrency Unions -- Frankel (Oct. 2009)
I combine the three substantial data sets on bilateral remittances that I know
of:
I find strong evidence of countercyclicality
Lueth & Ruiz-Arranz (2006, 2008), for an eclectic set of countries (mostly in
Europe & Asia), thanks to their generosity in supplying the data.
Jimnez-Martin, Jorgensen, & Labeaga (2007) for EU sending countries.
For Central American receiving countries (incl. DR, El Salvador & Panama)
I find strong evidence of countercyclicality.
763
Dependent Variable:
Table 3: Cross-Section 2003-04 --
Composite data set (merging three sources) Ln Remittances 2003-04 between Countries
(1) (2) (3) (4)
Ln (Stock migrants 2000 ) 0.762*** 0.741*** 1.061*** 1.233***
border/language/
border/language
islands/colonial
Instrumental variables
Observations 331 328 328 328
R2 0.526 0.546 0.463 0.351
Statistical significance: * 10% level, ** 5% level, *** 1% level
Three sources of remittance data for 2003-04: Central America data, FOMIN and the Central Banks; EU data: Jimnez-Martn, S., Jorgensen, N.
and Labeaga, J. M. (2007); IMF data: Lueth, E. and Ruiz-Arranz, M. (2006).
764
(ii) Level of financial development
Aghion, Bacchetta, Ranciere & Rogoff (2005)
767
Terms-of-trade variability returns
769
Inflation Targeting:
Its not just for rich countries anymore
Source: IMF Survey. October 23, 2000. Andrea Schaechter, Mark Stone, Mark Zelmer in the IMF, MEA Dept.
Online at: http://www.imf.org/external/pubs/ft/survey/2000/102300.pdf 770
The background papers for the high-level seminar Implementing Inflation Targets, 2000,
available on the IMF Website: http://www.imf.org/external/pubs/ft/seminar/2000/targets/index.htm
Inflation targeting is the reigning orthodoxy.
771
The shocks of 2007-2010 have shown
some disadvantages to Inflation Targeting,
analogously to how the emerging market crises of 1994-
2001 showed disadvantages to exchange rate targeting.
One disadvantage of IT:
no response to asset price bubbles.
Another disadvantage:
It gives the wrong answer in case of supply shocks:
E.g., in response to a rise in oil import prices,
it says to tighten monetary policy & appreciate, to keep CPI steady.
In response to a rise in world prices of export commodities,
it does not allow monetary tightening and appreciation.
772
Proposal to Peg the Export Price (PEP)
Intended for countries with volatile terms of trade,
particularly those specialized in the production of
mineral or agricultural commodity exports.
Proposal in its pure form:
The authorities peg the currency to a basket or
price index that includes the price of their leading
commodity export (oil, gold, copper, coffee),
rather than to the $ or or CPI.
My claim is that the regime combines the best of both worlds:
(i) The advantage of automatic accommodation to terms of
trade shocks, together with
(ii) the advantages of a nominal anchor and integration.
773
6 proposed nominal targets and the Achilles heel of each:
Targeted
Vulnerability Example
variable
774
PE
How would it work operationally, say,
P
for a Gulf oil-exporter?
But
Some volatility under floating appears gratuitous.
Floaters still need a nominal anchor.
The Rand, 1984-2006:
Fundamentals (real commodity prices,
real interest differential, country risk premium, & l.e.v.)
can explain the real appreciation of 2003-06 Frankel (SAJE, 2007).
200.000
180.000
160.000
140.000
120.000
100.000
80.000
60.000
40.000
Actual vs Fitted vs. Fundamentals-
20.000
Projected Values
0.000
84 85 85 86 87 88 88 89 90 91 91 92 93 94 94 95 96 97 97 98 99 00 00 01 02 03 03 04 05 06
19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20
Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1
RERICPIactual RERICPIFitted RERICPIProjected
PE
Why is PEP better than CPI-targeting
for countries with volatile terms of trade?
P
778
PE
PEP, in its strict form, has some disadvantages
P
Passes every fluctuation in world commodity prices
straight through to domestic-currency prices of other
TGs, creating high volatility
Even for countries where non-commodity TGs are a small share
of the economy, some would like to nurture this sector,
so as to encourage diversification in the long run.
Exposing it to full volatility could shrink non-commodity TG sector.
779
Moderate versions of PEP
PE
P
Target a broader Export Price Index (PEPI).
1st step for any central bank dipping its toe in these waters:
compute monthly export price index.
2nd step: announce that it is monitoring the index.
Fischer, Stanley, 2001, Exchange Rate Regimes: Is the Bipolar View Correct? Journal of
Economic Perspectives 15 (2).
Frankel, Jeffrey, 2003, Experience of and Lessons from Exchange Rate Regimes in Emerging
Economies, in Monetary and Financial Cooperation in East Asia, ADB ( Macmillan).
Frankel, 2009, A Comparison of Monetary Anchor Options for Commodity-Exporters in Latin
America and the Caribbean, Myths and Realities of Commodity Dependence: Policy Challenges
and Opportunities for Latin America and the Caribbean, World Bank, Sept.
Frankel, and Daniel Xie, 2010, Estimation of De Facto Flexibility Parameter and Basket Weights
in Evolving Exchange Rate Regimes, American Economic Review Papers & Proceedings 100, May.
Ghosh, Atish, Anne-Marie Gulde, and Holger C. Wolf, 2000, Currency Boards: More Than a
Quick Fix? Economic Policy 31.
Rogoff, Kenneth, and Maurice Obstfeld, 1995, The Mirage of Fixed Exchange Rates, J. of Econ.
Perspectives 9, No. 4 (Fall).
Rose, Andrew, 2000, One Money, One Market: Estimating the Effect of Common Currencies on
Trade, Economic Policy.
Taylor, Alan, 2002, A Century of Purchasing Power Parity, Rev. Ec. & Statistics, 84.
782
Additional Readings:
Arteta, Carlos, 2005, Exchange Rate Regimes and Financial Dollarization: Does Flexibility Reduce
Currency Mismatches, Topics in Macroeconomics 5, no. 1, Article 10.
Calvo, Guillermo, and Carmen Reinhart, 2002, Fear of Floating, Quarterly J. Economics, 117, no. 2.
Calvo, Guillermo, and Carlos Vegh, 1994, Inflation Stabilization and Nominal Anchors, Contemporary
Economic Policy, 12 (April).
Eichengreen, Barry, Paul Masson, Miguel Savastano, and Sunil Sharma, 1999, Transition Strategies and
Nominal Anchors on the Road to Greater Exchange Rate Flexibility, Essays in International Finance,
No. 213 (Princeton: Princeton University Press).
Frankel, Jeffrey, 2003, A Proposed Monetary Regime for Small Commodity-Exporters: Peg the Export
Price (PEP), International Finance, Spring.
___, A Proposal to Tie Iraqs Currency to Oil, Financial Times, June 13, 2003.
Frankel, and Andrew Rose, 1998, The Endogeneity of the Optimum Currency Area Criterion, The
Economic Journal.
___, and ___, 2002, An Estimate of the Effect of Common Currencies on Trade and Income,
Quarterly Journal of Economics.
Frankel, and Shang-Jin Wei, 2008, Estimation of De Facto Exchange Rate Regimes: Synthesis of the
Techniques for Inferring Flexibility and Basket Weights, IMF Staff Papers.
783
Additional Readings:
Friedman, Milton, 1953, The Case for Flexible Exchange Rates, in Essays in Positive Economics.
Husain, Asim, Ashoka Mody & Kenneth Rogoff, 2005, Exchange Rate Regime Durability and
Performance in Developing Vs. Advanced Economies JME 52 , Jan.35-64.
Ishii, Shogo, et al, Exchange Arrangements and Foreign Exchange Markets (IMF) 2003.
Levy-Yeyati, Eduardo, and Federico Sturzenegger, 2003, To Float or to Trail: Evidence on the Impact of
Exchange Rate Regimes, American Economic Review, 93, No. 4, Sept. .
McKinnon, Ronald, 1963, Optimum Currency Areas, American Economic Review, Sept., pp. 717-24
Mundell, Robert, 1961, A Theory of Optimum Currency Areas, AER, Nov., pp. 509-17.
Parsley, David, and Shang-Jin Wei, 2001, "Explaining the Border Effect: The Role of Exchange Rate
Variability, Shipping Costs, and Geography, Journal of International Economics, 55, no. 1, 87-106.
Reinhart, Carmen, and Kenneth Rogoff. 2004. The Modern History of Exchange Rate Arrangements: A
Reinterpretation. Quarterly Journal of Economics 119(1):1-48, February.
Tavlas, George, Harris Dellas & Alan Stockman, The Classification and Performance of Alternate
Exchange-Rate Systems, 2006.
Williamson, John, The Case for a Basket, Band and Crawl (BBC) Regime for East Asia, in D.Gruen &
J.Simon, eds., Future Directions for Monetary Policies in East Asia, Reserve Bank of Australia, 2001.
784