What hurts most?: G-3 exchange rate or interest rate volatility

With many emerging market currencies tied to the U.S. dollar either implicitly or explicitly, movements in the exchange values of the currencies of major countries have the potential to influence the competitive position of many developing countries. According to some analysts, establishing target bands to reduce the variability of the G-3 currencies would limit those destabilizing shocks emanating from abroad. This paper examines the argument for such a target zone strictly from an emerging market perspective. Given that sterilized intervention by industrial economies tends to be ineffective and that policy makers show no appetite to return to the controls on international capital flows that helped keep exchange rates stable over the Bretton Woods era, a commitment to damping G-3 exchange rate fluctuations requires a willingness on the part of G-3 authorities to use domestic monetary policy to that end. Under a system of target zones, then, relative prices for emerging market economies may become more stable, but debt-servicing costs may become less predictable. We use a simple trade model to show that the resulting consequences for welfare are ambiguous. Our empirical work supplements the traditional literature on North-South links by examining the importance of the volatilities of G-3 exchange-rates, and U.S. interest rate and consumption on capital flows and economic growth in developing countries over the past thirty years.capital flows trade exchange rate volatility interest rates debt emerging markets advanced economies

Output Fluctuations and Monetary Shocks: Evidence from Colombia

Using annual data for Colombia over the last 30 years, we test competing theories that explain macroeconomic fluctuations: the neoclassical synthesis, which posits that in the presence of temporary price rigidity, an unanticipated monetary expansion produces output gains that erode over time with increases in the price level; and an alternative explanation, which focuses on "real" technological or preference shocks as sources of output changes. Coefficients from this system are used to examine the long-run neutrality of nominal quantities with respect to permanent movements in the money stock and the short-run sensitivity of output to inflation.Colombia, inflation, growth, exchange rates,VAR

Is the US too big to fail?

Why are investors rushing to purchase US government securities when the US is the epicentre of the financial crisis? This column attributes the paradox to key emerging market economies’ exchange practices, which require reserves most often invested in US government securities. America’s exorbitant privilege comes with a cost and a responsibility that US policy makers should bear in mind as they handle the crisis.financial crisis, exchange rates, reserves,government

On the use of reserve requirements in dealing with capital flow problems

In recent years, many developing countries have intervened in foreign exchange markets to offset to some extent the effect on their economies of large capital flows. Often, changes in reserve requirements were used to mitigate the impact of that intervention on domestic money supplies. Because reserve requirements are a tax, however, changes in reserve requirements can have real effects. This paper shows that the exact implications for output, the real exchange rate, and the capital and current accounts depend importantly on who--whether depositors or borrowers--pays the tax. In any case, foreign exchange intervention matched by changes in reserve requirements that keep the money supply fixed do influence the exchange rate in the short and, sometimes, the long run. The recent experiences of ten developing countries establish that, while the incidence of the tax varies considerably across countries and time, both deposit and lending rates of interest respond to changes in reserve requirements.capital flows countercyclical policies capital mobility reserve requirements

From Capital Flow Bonanza to Financial Crash

The standard pattern: capital flows into the new “hot” nation, but then stop or reverses forcing painful adjustment. This column presents research based on such episodes from 181 nations during 1980-2007 and for a subset of 66 nations for the 1960-2007 period. If the pattern of the past few decades holds true, emerging market economies may be facing a darkening future.international capital flows, crses procyclical polices

The Capital Inflow “Problem” Revisited

Capital inflows can be a mixed blessing, especially in economies with thin domestic financial markets and when driven by investors with a short-term focus. Many levers of policy can be applied to resist the effects of the inflows. One that has been widely relied upon has been currency intervention. Key to that appears to be keeping their bilateral exchange rate stable vis-à-vis the U.S. dollar. But this requires them to resist currency appreciation and accumulate dollar reserves when the anchor country is mired in financial problems and keeps monetary policy accommodative in an unprecedented manner. The willingness of emerging market economies to limit exchange rate fluctuations will be tested as monetary policy in advanced economies remains geared toward domestic considerations. Meanwhile, some advanced economies will be looking to finance large deficits and to roll over large debts. In that environment, prior reticence toward capital controls and other restrictions on finance may well lift. For emerging markets, this insulates them from monetary policy in advanced economies that may be inappropriate for domestic circumstances. For advanced economies, this limits the competition for the debt they dearly have to sell. In such a world, the policy tools we discussed will be increasingly relied upon.capital flows, reserves, exchange rates,capital controls

When the North Last Headed South: Revisiting the 1930s

The U.S recession of 2007 to 2009 is unique in the post-World-War-II experience by the broad company it kept. Activity contracted around the world, with the advanced countries of the North experiencing declines in spending normally the purview of the developing economies of the South. The last time that the economies of the North similarly headed south was the 1930s. This paper examines the role of policy in fostering recovery in that decade. With nominal short-term interest rates already near zero, monetary policy in most countries took the unconventional step of delinking currencies from the gold standard. However, analysis of a sample that includes developing countries shows that this was not as universally effective as often claimed, perhaps because the exit from gold was uncoordinated in time, scale, and scope and, in many countries, failed to bring about a substantial depreciation against the dollar. Fiscal policy was also active in the 1930s—many countries sharply increased government spending—but prone to reversals that may have undermined confidence. Countries that were more consistent in keeping spending high tended to recover more quickly.debt, fiscal policy, exchange rates, monetary policy, depression, international, crisis

Twin fallacies about exchange rate policy in emerging markets

Two assertions about exchange rate regimes circulate with some frequency in policy circles. The first, the hypothesis of the excluded middle, holds that authorities must either choose perfectly floating exchange rates (preferably anchored by an inflation target for the central bank) or a hard (preferably irrevocable) peg. The second, seemingly unrelated, argues that the inability of emerging market economies to exercise monetary independence owes to the severe mistrust that they are perceived with by global investors because of the economic failures of prior governments. This paper argues that the theories of the excluded middle and original sin are twin and related fallacies that are contrary to theory and evidence. This paper will provide a model in which the government can choose policies consistent with either a pure float anchored by a constant money stock or a pure peg but, under certain circumstances, fail to find exchange rate stability at either corner. The problem is that the potential for regime change implies that the current government’s successors may behave less admirably, which will weigh on investors’ current behavior. The difficulties imparted by this expectation channel in an otherwise standard model of optimizing agents endowed with rational expectations shows both why looking back to explain credibility problems is looking the wrong way and why the excluded middle is, in fact, so crowdedexchange rate policy fixed bipolar view foreign currency debt credibility

Twin fallacies about exchange rate policy: A note

Two assertions about exchange rate regimes circulate with some frequency in policy circles. The first, which could be called the hypothesis of the excluded middle, holds that authorities must either choose perfectly floating exchange rates or a hard peg. The second, seemingly unrelated, notion attempts to explain why policy makers in some countries have little credibility. That mistrust, exemplified by the inability of emerging market economies to borrow at long maturities in their own currencies (original sin), transcends current fundamentals and traces back to the failure of prior policy makers. We argue that the theories of the excluded middle and original sin are twin and related fallacies that are contrary to theory and evidence. The sense that credibility problems stem from a simple and irrational source–failures of prior generations of policy makers–lends credence to alternative regimes that seem to allow the easy purchase of investor confidence–an exchange rate regime at one of the corners. Two decades of theory and empirical evidence cumulate to argue that this is too simple an answer. As to the theory, the literature on time inconsistency has amply demonstrated that the inability to precommit future policy decisions gives reason to doubt that the current regime will be maintained. That doubt stems, not from the record of prior failures, but from the inconsistency of incentives in the future.exchange rate debt domestic currency original sin

Forecasting turning points in Canada

Economists have long been involved in the search for a few key indicators that predict the behavior of market economies. For Canada, it has been shown that the yield curve reliably tilts down and that real M1 growth declines before economic contraction, but this has been demonstrated almost exclusively in the context of single estimation equations or atheoretical VARs. This paper offers an alternative approach to the study of economic turning points. To qualify as a business-cycle indicator, a variable must behave differently when an economy is approaching or in recession than it does during economic expansions. That simple logic admits a variety of parametric and nonparametric tests of a variable’s usefulness, in forecasting. We examine the behavior around recessions of sixteen Canadian and U.S. time series. In the end we find that only the slopes of the Canadian and the U.S. term structure meet the prespecified criteria; the change in the nominal MCI and in real M1 follow behind.business cycles monetary policy yield curve interest rates