0 Política Monetaria

Basic Points About Money
Origin of money with Goldsmiths; Bank of England -1994
What is money?
Currency, Demand and time deposits, Financial assets

and other liquid assets
Why do people want 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
Targets: inflation only; or money supply only; or exchange

rate only; all of them; or two of them; or none of them.
Instruments: Open market operation on treasury bills -

rediscounting
Fixing the interest rate, credit control
Money supply rule, reserve requirement
Deposit insurance
Effectiveness of monetary policy depends upon
Central bank independence and credibility ie, who appoints
the governor?
Moral hazards - bank panics, systematic risk, regulation -
bank supervision
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
Two Conditions to have real effect of Monetary policy

Central bank controls monetary base M1 = R + Cu
Prices do not adjust instantaneously
M
M i, r C , I , X , G Y P i, r
P
3
Effects of Changes in the Rate of Interest
First round effects
Households: saving, housing, wealth,

foreign asset, portfolio allocations
Firms: cost of capital, debt-equity,
portfolio allocations P 1 i P P P2
2 1 1
1 i
Second round effects: consumption
spending, additional demand for goods
Time lags: anticipated and unanticipated

policy changes.
4
An Increase in Money Supply Can Lower Real
and Nominal Interest Rates in the Short but not in the Long Run
M
M i, r C , I , X , G Y P i, r
P
iT rn
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
Interest rate Channel Credit Channel

Lower interest rate Lower interest
More borrowing and Spending More reserves
More aggregate demand More lending
Open Market Operation Higher aggregate demand
Deficit financing
Rediscounting of Treasury Bills
Exchange Rate Channel

Lower interest rate Balance Sheet Channel
Depreciation of domestic currency Lower interest rate
More exports and less imports Increase in prices of stocks, bonds and
other assets
Higher aggregate demand
More wealth
Buy back own currencies selling some foreign
More aggregate demand
assets to avoid depreciation - sterilisation
Moral hazards - bank panics, systematic risk,
selling its currency to avoid appreciation
regulation - bank supervision
6
Open Market Operation: Interest Rate Channel
Expansionary Monetary Policy

Short run:
Central bank reduces the repo rate
Commercial banks and financial institutions find
it profitable to sell bonds to the central bank
Central bank raises their reserves
Commercial banks have more money to lend
Firms and households find it cheaper to borrow
They borrow and create more deposits
Demand for goods and services rises
Money supply expands
Long run:
Prices will eventually rise following higher demand
Real money supply (M/P) shrinks
Interest rises back to natural position
7
Open Market Operation: Interest Rate Channel
Contractionary Monetary Policy
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
Missing Link for Keynes
11
Keynesian View on Monetary Policy : Main Points
Monetary affects real economy through the interest
rate.
Interest rate is determined by the supply and demand

in the money market.
Three kinds of demand

Speculative Demand
Transaction Demand
Precautionary Demand
Demand for money is not stable because of chaning

velocity of money. People do not spend and the
velocity is low in depression and high in the boom.
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
Interest Interest rate

Rate
Demand for and Supply of Money Demand for bonds
Money supply is controlled by the policy maker

13
Basic Structure of the Keynesian Static Model for Monetary Policy
Consumption: C a bY d (1)
Disposable income: Y Y T
d
(2)
Investment: I r I 0 q r (3)
M
Demand for real balances: P kY r (4)
National income identity: Y C I G (5)
1 M
Money Market Equilibrium: r kY (6)
P
Aggregate Demand Consistent with Goods and Money
Market Equilibrium:
q M
a bT I 0 G
1
a bT I 0 q kY
M
G
P
P Y
Y q
1 b
; 1 b k (7)

Equilibrium Interest Rate:
qM
a bT I G
k 0
P M
r
1 b k
q P (8)

14
Multiplier Effect of Increase in Money Supply on Output and Interest Rate
Y ha, b, q,, k , M , G, T , P (9)
Impact on Output from Increase in Money Supply :
Y q
0
M q (10)
1 b k

Impact on Output from Increase in Public Spending:
Y 1
0
G q (11)
1 b k

Impact on Interest rate from Increase in Money Supply :
q
r k
1 0
M q
1 b k (12)

P
Impact on Interest rate from Increase in Public Spending:

r k 1
0
G 1 b k q (13)

Shortcoming of the Keynesian Model: Missing Supply Side
15
Controversy Over Macroeconomic Impacts of Fiscal and Monetary Policies
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
If we considering a leakage in the currency holding:

m1 c r R
c C
r c where D D What is the value of the
money multiplier if
M R C (a) r = 10% and c = 20 %?
0
M C D (b) m = 4.
4
M
then dividing (b) by (a) 4 D C 1 c .
M C R cr
0
If people held more currency then multiplier becomes
smaller. 17
Money Demand
Quantity theory of Money (QTM): MV = PT
Cambridge equation of money demand:
M kY 1
M PY

=>
P k
Keynesian money demand

M
kY r
P
Friedman type money demand
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.
Monetary authority can control nominal quantities such

as it liabilities, M0, M3 or M4. By controlling them it
can stabilise the price level.
Price mechanism in the market system works better when

prices are stable and relative prices can adjust according
to the dynamics of the economic system.
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
Transmission mechanism of monetary policy: impact of of interest decision in the economy

An Open Economy with the interest rate and exchange rate
Why low interest keeps house prices rising despite fall in the stock prices?
Money demand: substitution between money and bond.
Money multipliers
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
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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;
restrict the development of financial
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
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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;
refinance and discount facilities;
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;
: measures the riskiness of the project.

47
l Projects yield either R (if they succeed) or 0 (if they
fail).
l The higher value represents an increase in risk.
An increase in captures an increase in the
variance of the project's return, while leaving its
mean constant. Shifts in are thus assumed to be
mean preserving.
l Borrower receives the fixed amount of loans, L, at
the contractual interest rate r and defaults on the
loan if the project's return R plus the value of the
collateral C are insufficient to repay the loan.
l Bank receives either the full contractual amount
(1+r)L or the maximum possible, R + C.
48
l If lenders face no collection or enforcement
costs, the return to the bank is:
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
applicants, less risky borrowers drop out of the

market;
l adverse incentive effect, or moral hazard effect:
Borrowers are induced to choose projects for
which the probability of default is higher (because

riskier projects are associated with higher
expected returns).
This has a negative effect on the lender's expected
profit, which may dominate the positive effect of an

increase in the contractual interest rate. 50
~
First result (/r > 0):
l positive effect of an increase in the contractual
interest rate on the bank's expected rate of return
on its loans, , may be partly offset by the negative
effect due to the increase in the riskiness of the
pool of borrowers.
l If the latter effect dominates, will not be
monotonically related to r and rationing may incur
in equilibrium.
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
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ci
a
lba
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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
those emphasized by Stiglitz and Weiss may

result if lenders attempt to raise mean returns by
increasing the collateral required from borrowers.
Bester (1985): if lenders can vary both collateral
requirements and the contractual loan rate to

screen loan applicants, the possibility of a
rationing equilibrium disappears.
61
Stiglitz and Weiss (1992): even if banks are able
to manipulate interest rates and collateral,
rationing may still emerge in equilibrium if
borrowers are subject to decreasing absolute
risk aversion.
l Absence of collection and verification costs.
Asymmetry of information is ex ante: although
projects differ in their distributions of return before

implementation, lenders can observe actual
outcomes.
Williamson (1986): assume that projects are ex
ante identical but lenders must incur ex post

monitoring and enforcement costs to
4 verify the outcome of the project and
62
4 legally enforce the terms of the loan contract if
the borrower chooses to default.
Credit market imperfections may be particularly
relevant for developing countries, where
enforcement of loan contracts may be difficult
due to the severe weaknesses in the legal
system.
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
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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
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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
Open market operations

Affect the quantity of reserves and the monetary base
Changes in borrowed reserves
Affect the monetary base
Changes in reserve requirements
Affect the money multiplier
Federal funds ratethe interest rate on overnight loans of
reserves from one bank to another
Primary indicator of the stance of monetary policy
18-84
Demand in the Market for Reserves
What happens to the quantity of reserves demanded, holding

everything else constant, as the federal funds rate changes?
Two components: required reserves and
excess reserves
Excess reserves are insurance against deposit outflows
The cost of holding these is the interest rate that could
have been earned
As the federal funds rate decreases, the opportunity cost of
holding excess reserves falls and the quantity of reserves
demanded rises
Downward sloping demand curve
18-85
Supply in the Market for Reserves
Two components: non-borrowed and

borrowed reserves
Cost of borrowing from the Fed is the discount rate
Borrowing from the Fed is a substitute for borrowing from
other banks
If iff < id, then banks will not borrow from the Fed and
borrowed reserves are zero
The supply curve will be vertical
As iff rises above id, banks will borrow more and more at id,
and re-lend at iff
The supply curve is horizontal (perfectly elastic) at id
18-86
18-87
Affecting the Federal Funds Rate
An open market purchase causes the federal

funds rate to fall; an open market sale causes
the federal funds rate to rise shifting the
supply curve
If the intersection of supply and demand
occurs on the vertical section of the supply
curve, a change in the discount rate will have
no effect on the federal funds rate
18-88
Affecting
the Federal Funds Rate (contd)
If the intersection of supply and demand occurs on

the horizontal section of the supply curve, a change
in the discount rate shifts that portion of the supply
curve and the federal funds rate may either rise or
fall depending on the change in the discount rate
When the Fed raises reserve requirement, the
federal funds rate rises and when the Fed decreases
reserve requirement, the federal funds rate falls
shifting the demand curve
18-89
18-90
18-91
18-92
Open Market Operations
Dynamic open market operations

Defensive open market operations
Primary dealers
TRAPS (Trading Room Automated Processing
System)
Repurchase agreements
Matched sale-purchase agreements
18-93
Advantages of
The Fed has complete control over

the volume
Flexible and precise
Easily reversed
Quickly implemented
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
Used to perform role of lender of

last resort
Cannot be controlled by the Fed; the decision
maker is the bank
Discount facility is used as a backup facility to
prevent the federal funds rate from rising too
far above the target
18-97
Reserve Requirements
Depository Institutions Deregulation and Monetary

Control Act of 1980 sets the
reserve requirement the same for all depository
institutions
3% of the first $48.3 million of checkable deposits;
10% of checkable deposits over $48.3 million
The Fed can vary the 10% requirement between 8%
to 14%
18-98
Disadvantages
of Reserve Requirements
No longer binding for most banks

Can cause liquidity problems
Increases uncertainty
Recommendations to eliminate
18-99
The Channel/Corridor System
Sets up a standing lending facility (lombard

facility) and stands ready to loan overnight
any amount banks ask for at a fixed interest
rate (lombard rate)
The supply of reserves is infinitely elastic at
this interest rate
Another standing facility is set up that pays
banks a fixed interest rate on any deposits
they would like to keep at the central bank
18-100
The Channel/Corridor System (contd)
The supply of reserves is also infinitely elastic

at this interest rate
In between these two interest rates
the quantity supplied is equal to the
non-borrowed reserves
The demand curve has its usual downward
slope
18-101
18-102
Monetary Policy Tools
of the European Central Bank
Open market operations

Main refinancing operations
Weekly reverse transactions
Longer-term refinancing operations
Lending to banks
Marginal lending facility/marginal
lending rate
Deposit facility
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
Traditional policy tools are:

1. Open market operations (Feds securities usually Treasuries trading)
2. Discount policy (setting discount % & discount lending terms, for banks liquidity)
3. Reserve requirement (% of checkable deposits held as vault cash or Fed deposits)
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).
Fed determines reserves (R), discount % (id)

(iff ceiling: borrow from banks/Fed if iff </= id, S
horizontal) & % on banks reserves at Fed (irb)
(floor for iff : arbitrage if iff < irb, D horizontal).
S vertical because supply of reserves

independent of federal funds rate due to Feds
control over reserves.
Home mortgage & corporate bond

rates move w/ federal funds rate.
107
Effects of Open Market Operations on the
Federal Funds Market
Purchases Lower Federal Funds % Sales Raise Federal Funds %

Supply curve shifts right (S1S2). Supply curve shifts left
Equilibrium reserves (R*1R*2) while (S1S2).
equilibrium federal funds % (1.51%). Equilibrium reserves
Discount % also (1.751.25%). (R*1R*2) while equilibrium
federal funds % (55.25%).
108
The Effect of Changes in the Discount Rate and in Reserve Requirements
Changes in the Discount Rate

Since 2003 Fed kept discount rate > target for the federal funds rate. So, discount rate
is penalty rate, as banks pay a penalty when borrow from Fed rather than other banks.
Changes in the Required Reserve Ratio

Fed rarely changes required reserve ratio. Likely combined w/ offsetting open market
operations to keep target federal funds rate unchanged.
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 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.
Implementing Open Market Operations

FOMC issues policy directive to Fed Reserve Systems account manager (NY Fed VP).
Each morning, trading desk notifies primary dealers on size of trades & asks for offers.
Dealers have just a few minutes to respond. Feds account manager accepts the best
offers & trading desk trades until reserves reaches Feds desired goal.
Dynamic open market operations change monetary policy as directed by FOMC (usually
outright Treasuries trading w/ primary dealers).
Defensive open market operations offset temporary fluctuations in reserves ( due to

check clearing delays from snow or US government purchases), not to change monetary
policy (usually repurchase agreements).
111
Why Cant the Fed Always Hit Its Federal Funds Target?
Fed sets target for federal funds %. Demand/supply for reserves determines actual %.
NY Fed uses open market operations to keep actual & target federal funds % close.
Open market operations give Fed control, flexibility & ease of implementation w/o
administrative delays.
Discount loans depend on
banks willingness to request
loans (not completely under
Feds control).
Changing discount % or
reserve requirements
takes longer.
Fannie Mae & Freddie Mac (government agencies - major

buyers of residential mortgages - frequently drive federal funds
% below interest on reserve deposits.
112
Discount Policy
Since 1980, all depository institutions had access to discount window. Each Federal
Reserve Bank maintains its own discount window, although all charge same rate.
Categories of Discount Loans

Primary credit available to healthy banks experiencing temporary liquidity problems.
Secondary credit to banks that are not eligible for primary credit.
Seasonal credit to smaller banks in areas where agriculture or tourism is important.
Discount Lending during the Financial Crisis of 20072009

Initially fin crisis involved shadow banks, Feds problem - it typically lends to banks.
Then Fed set up temporary lending facilities ( landing from few $100M to $993.5B):
Primary Dealer Credit Facility: Loans for investment banks & large securities firms.
Term Securities Lending Facility: For financial firms to borrow against illiquid assets.
Commercial Paper Funding Facility: Direct purchased from firms to continue operations.
Term Asset-Backed Securities Loan Facility (TALF): NY Fed extended 3 or 5 year loans
to investors for purchase of asset-backed securities.
Term Auction Facility: Auctioned discount loans at rate determined by banks demand.
113
Monetary Targeting and Monetary Policy
Fed faces trade-offs to reach its goals (high growth & low inflation) & timing difficulties:
Information lag is Feds inability to observe instantaneously changes in econ variables.
Impact lag is time required for monetary policy affect output, employment or inflation.
Possible solution to timing problems is to use targets (variables Fed can
influence directly that help achieve monetary policy goals) to meet its goals.
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*.
If demand for reserves or shifts right If demand for reserves or

(D1D2), equilibrium federal funds %
(i*ff1i*ff2).
shifts right (D1D2), Fed has
to supply of reserves
(S1S2) to maintain target 117
The Taylor Rule: A Summary Measure of Fed Policy
Fed deliberations are complex & incorporate many econ factors summarized in
Taylor rule: monetary policy guideline for estimating target for federal funds % (after
inflation adjustment) consistent with RGDP = potential RGDP in the long run.
Federal Current Equilibrium Inflation gap Output gap
funds = inflation + real federal + ---------------- + ---------------
target funds % 2 2
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 %.
Historically, Taylor rule explains

Fed policy reasonable well only
during some periods.
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.
Arguments against an inflation target:

1. Rigid numerical targets for inflation diminish flexibility.
2. Reliance on uncertain forecasts of future inflation can create problems.
3. Difficult for elected officials to monitor Feds support for overall econ policy.
4. Future output & employment uncertainty impedes decisions in w/ inflation target.
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 German Central Bank (Bundesbank)

Experimented with monetary targets in late 1970s to combat inflation.
Used central bank money = weighted currency, checkable, time & savings deposits.
Succeeded in maintaining its target ranges for M3 growth in early 1980s.
West & East German currency differences had inflationary pressures after reunification.
Used lombard rate (short-term repurchase agreement rate) to achieve its M3 target.
120
Relinquished monetary policy to European Central Bank after 2002 introduction of .

The Bank of Canada
Gradually reduced M1 growth in early 1970s as inflation became a concern.
Shifted its policy toward an exchange rate target in the late 1970s.
Reinstated inflation commitment in 1988 (declining inflation & overnight rate targets).
Focused on exchange rates reflecting importance of exports).
Helped fin system avoid heavy losses suffered by many banks during 2007-09 crisis.
The Bank of England

Announced (but not pursued) money supply targets in response to late 1973 inflation.
In response to 1970s inflation introduced (unachievable) deceleration of M3 growth.
Shifted emphasis toward targeting monetary base growth beginning in 1983.
Inflation targets in 1992 & short-term interest % primary instrument of monetary policy.
Took several dramatic policy actions during fin crisis, cutting its overnight base rate.
Rapidly lowered rate it paid on reserves, and engaged in quantitative easing.
The European System of Central Banks (ECB + EU members central banks)

Operates since 1999, modeled after Bundesbank, with price stability as its primary goal.
Secondary objective to support general econ policies of European Union.
Attaches significant role to monetary aggregates.
Despite emphasis on price stability, not committed monetary or an inflation-targeting.
Struggled monetary w/ policy for different needs of member countries during crisis.
Received further strains in 2012 by intervening in Greeces sovereign debt crisis. 121
Introduction
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
The central bank of the U.S. is the Federal Reserve (Fed).

The people who work there are responsible for making sure that our financial system
functions smoothly so that the average citizen can carry on without worrying about it.
15-123
Introduction
In Part IV, we will study the evolving role of central banks.

Central banks do not act only during times of crisis.
Their work is vital to the day-to-day operation of any modern economy.
Today there are roughly 170 central banks in the world.
Most people only have a vague idea of what central banks do.
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
King William of Orange created the central bank to finance wars.

Napoleon Bonaparte did it in an effort to stabilize his countrys economic and financial
system.
These examples are more an exception because central banking is largely a 20th century
phenomenon.
15-127
In 1900, only 18 countries had a central bank.

The U.S. Federal Reserve began operation in 1914.
As the importance of a government and the financial system grew, the need for a central
bank grew along with it.
15-128
As the governments bank, the central bank has a privileged position:

It has the monopoly on the issuance of currency.
The central bank creates money.
Early central banks kept sufficient reserves to redeem their notes in gold.
Today, the Fed has the sole legal authority to issue U.S. dollar bills.
15-129
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
Why would a country want to have its own monetary policy?

1. At its most basic level, printing money is a very profitable business.
A bill only costs a few cents to print.
2. Government officials also know that losing control of the printing presses
means losing control of inflation.
A high rate of money growth creates a high inflation rate.
15-131
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
No bank, no matter how well managed, can withstand a run.

To stave off such a crisis, the central bank can lend reserves or currency to sounds banks.
By ensuring that sound banks and financial institutions can continue to operate, the central
bank makes the whole financial system more stable.
15-136
The Bankers Bank
Every country needs a secure and efficient payments system.

Financial institutions need a cheap and reliable way to transfer funds to one
another.
The fact that all banks have account at the central bank makes the it the natural place
for interbank payments to be settled.
In 2009, an average of more than $2.5 trillion per day was transferred over Fedwire.
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
It is essential that we understand what a central bank is not.

It does not control securities markets, though it may monitor and participate in bond
and stock markets.
It does not control the governments budget.
That is determined by Congress and the president through fiscal policy.
The Fed only acts as the Treasurys 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
We can easily see examples of failure:

1. The Great Depression of the 1930s when the banking system collapsed.
Economic historians state that the Fed failed to provide adequate money
and credit.
2. The crisis of 2007-2009
The Fed was largely passive as intermediaries took on increasing risk amid
the housing bubble.
It also allowed the crisis to intensify for more than a year after it had begun.
15-143
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
It is important to realize that instability in any of these poses an economy-wide risk

that individuals cant diversify away.
The job of the central bank is to improve general economic welfare by managing and
reducing risk.
Understand that it is probably impossible to achieve all five of their objectives
simultaneously.
Tradeoffs must be made.
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
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
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
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
Zero inflation would also be difficult for companies.

If an employer wished to cut labor costs, it would need to cut nominal wages which is
difficult to do.
So, a small amount of inflation makes labor markets work better, at least from an employers
point of view.
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
To foster maximum sustainable growth in output and employment is one of Chairman

Bernankes goals.
This means he is working to dampen the fluctuations of the business cycle.
By adjusting interest rates, central bankers work to moderate these cycles and stabilize
growth and employment
15-152
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
A period of above-average growth has to be followed by a period of below-average growth.

The job of the central bank during such periods is to change interest rates to adjust growth.
In the long run, stability leads to higher growth.
The greater the uncertainty about future business conditions, the more cautious people
will be in making investments of all kinds.
15-154
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
Why is interest-rate volatility a problem?

1. Most people respond to low interest rates by borrowing and spending more and
vice versa.
Interest-rate volatility makes output unstable.
2. Interest-rate volatility means higher risk and therefore a higher risk premium.
Risk makes financial decisions more difficult, lower productivity, and lessen
efficiency.
15-159
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
In the past several decades, overall economic conditions improved nearly

everywhere.
This was especially true in rapidly growing emerging economics such as Brazil,
China and India.
Growth was higher, inflation was lower, and both were more stable than in the 1980s.
What explains this long period of stability?
15-165
A prime candidate is that technology sparked a boom just as central banks

became better at their jobs.
1. Monetary policymakers realized that sustainable growth had gone up, so
they could keep interest rates low without worrying about inflation.
2. Central banks were redesigned.
Many believe that improvements in economic performance during the 1990s
were related at least in part to the policy followed by these restructured central
banks.
15-166
Today economists are exploring how to improve financial regulation, and

reconsidering the role that central banks should play in financial supervision.
To be successful, a central bank must:
1. Be independent of political pressure,
2. Make decisions by committee,
3. Be accountable to the public and transparent in communicating its policy
actions, and
4. Operate within an explicit framework that clearly states its goals and makes
clear the trade-offs among them.
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
Independence has two operational components.

1. Monetary policymakers must be free to control their own budgets.
2. The banks policies must not be reversible by people outside the central bank.
The U.S. Federal Open Market Committees decisions cannot be overridden
by the President, Congress or the Supreme Court.
15-169
Successful monetary policy requires a long time horizon.

The temptation to forsake long-term goals for short-term gains is impossible for most
politicians to resist.
Knowing these tendencies, governments have moved responsibility for monetary policy into
a separate, largely apolitical, institution.
15-170
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?
Realization that independent central

bankers would deliver lower inflation than
they themselves could.
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
Central bank independence is inconsistent with representative democracy.

How can we have faith in our financial system if there are no checks on what the central
bankers are doing?
Proponents of central bank independence had a twofold solution.
15-175
1. Politicians would establish a set of goals.

2. The policymakers would publicly report their progress in pursuing those goals.
Explicit goals foster accountability and disclosure requirements create transparency.
The institutional means for assuring accountability and transparency differ from one
country to the next.
15-176
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 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
To meet these objectives, central bankers must be independent, accountable, and

good communicators.
These qualities make up what we call the monetary policy framework.
This exists to resolve ambiguities that arise in the course of the central banks
work.
Officials have told us what they are going to do.
This helps people plan and keeps officials accountable to the public.
15-179
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
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
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
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
By specifying a range of acceptable levels of borrowing, Europeans are trying to

restrict the fiscal policies that member countries enact.
For the European Central Bank to do its job effectively, all the member countries
governments must behave responsibly.
Funding needs create a natural conflict between monetary and fiscal policy makers.
15-186
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
Some fiscal policymakers resort to actions intended to get around restrictions

imposed by the central bank.
This erodes what is otherwise an effective and responsible monetary policy.
Today the central banks autonomy leaves fiscal policymakers with two options for
financing government spending.
Take a share of income and wealth through taxes.
Borrow by issuing bonds in the financial markets.
15-188
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
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
Both these policies must be reversed to prevent a large future inflation.

When faced with a fiscal crisis, politicians often look for the easiest way out.
If that way is inflating the value of the currency today, they will worry about the
consequences tomorrow.
Monetary policy can meet its objective of price stability only if the government lives
within its budget and never forces the central bank to finance a fiscal deficit.
15-191
Responsible fiscal policy is essential to the success of monetary policy.

There is no way for a poorly designed central bank to stabilize prices, output, the
financial system, and interest and exchange rates, regardless of the governments
behavior.
To be successful, a central bank must be independent, accountable, and clear about
its goals.
It must also have a well-articulated communications strategy and a sound decision-
making mechanism.
15-192
Monetary Policy &
Commodity Prices
Jeffrey Frankel
Harvard University & NBER
193
The Choice of Monetary Regimes
for Emerging Markets / Developing Countries
I. How are DCs structurally different

from Advanced Economies?
II. Choice of exchange rate regime
III. Alternative anchors for monetary policy

-- Proposal for Nominal GDP Targeting
194
I. How are EMs & Developing Countries different from Advanced Economies?
1. Need for monetary credibility.
2. Supply shocks.
3. Terms of trade shocks.
195
How are EMs different from Advanced Economies? continued
1. Monetary policy-makers have

more need for credibility
a) due to high-inflation histories,
b) absence of credible institutions,
c) or political pressure to monetize big budget deficits.
A. Fraga, I. Goldfajn & A. Minella (2003),

Inflation Targeting in Emerging Market Economies,
NBER Macro Annual 2003, K.Rogoff & M.Gertler, eds. (MIT Press).
196
How are EMs different from Advanced Economies? continued
1.
2. The economy is more exposed to supply shocks

a) such as natural disasters
(hurricanes, cyclones, earthquakes, tsunamis)
b) other weather events (droughts),
c) social unrest (strikes),
d) productivity shocks (Are we the next Tiger economy?).
3. And more exposed to terms of trade shocks.

a) Volatility in price of export commodity on world markets
b) Volatility in price of imports on world markets.
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
Intermediate exchange rate regimes

E.g., systematic managed float.
199
vantages of fixed rates
1) Encourage trade <= lower exchange risk

& lower transaction costs.
E.g., Rose (2000): currency unions triple trade among members.
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.
4) Avoid competitive depreciation (currency wars)
5) Avoid speculative bubbles that afflict floating.

(vs. if variability is fundamental real exchange rate risk,
it will just pop up in prices instead of nominal exchange rates).
Advantages of floating 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.)
Professor Jeffrey Frankel

201
Which dominate: advantages
of fixing or advantages of floating?
The answer depends on circumstances.

No one exchange rate regime is right
for all countries or all times.
Traditional criteria for choosing - Optimum Currency Area.
Focus is on stabilization of trade balance & business cycle.
1990s criteria for choosing

Focus is on stabilization of financial markets.
Additional criteria relevant for developing countries -
-- Financial development
-- Terms of trade volatility. 202
Optimum Currency Area Theory (OCA)
Broad definition: An optimum currency area is a region

that should have its own currency and own monetary policy.
This definition can be given more content:

An OCA can be defined as: a region that is neither so small
and open that it would be better off pegging its currency
to a neighbor, nor so large that it would be better off
splitting into sub-regions with different currencies.

203
Optimum Currency Area criteria
for fixing exchange rate:
Small size and openness

because then the advantages of fixing are large.
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.
Fiscal transfers in a federal system

because then consumption is cushioned in a downturn.

204
(i) Level of financial development
Fixed rates are better for countries with low financial development because markets are thin:
=> costs of financial shocks outweigh benefits of accommodating real shocks.
As financial markets develop, exchange flexibility becomes more attractive.

Estimated threshold: Private Credit/GDP > 40%.
Aghion, Bacchetta, Ranciere & Rogoff (2005).
For richer & more financially developed countries,

flexible rates work better:
more durable & deliver higher growth without inflation
Husain, Mody & Rogoff (2005).

205
(ii) External Shocks
An old wisdom regarding the source of shocks:

Fixed rates work best if shocks are mostly internal demand shocks (especially monetary);
floating rates work best if shocks tend to be real shocks (especially external terms of trade).
One case of supply shocks: natural disasters

R.Ramcharan (2007) finds support.
Most common case of real shocks: trade

206
Terms-of-trade volatility
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).

207
Cspedes & Velasco (Nov.2012) NBER WP 18569
Macroeconomic Performance During Commodity Price Booms & Busts
** Statistically Constant term

not reported.
significant
(t-statistics in
at 5% level. parentheses.)
Across 107 major commodity boom-bust cycles,

output loss is bigger, the bigger is the commodity price change
& the less is exchange rate flexibility. 208
Conclusion: Desirable exchange rate regime
Very small, very open, economies usually

find that the advantages of fixing dominate.
Very large countries like US & euroland usually

find that the advantages of floating dominate.
Most countries are in between,
particularly middle-sized middle-income countries.
Most of these countries should have

intermediate exchange rate regimes,
neither firm fixing nor free floating.
Intermediate regimes include band & basket arrangements.
209
Distribution of EM exchange rate regimes
The big rise is in the managed float category

Distribution of
Exchange Rate
Regimes in Emerging
Markets, 1980-2011
(percent of total)
}
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.
But Stan Fischer has a good point:

giving speculators a target to shoot at
is often a losing proposition,
such as the boundary of a declared band.
A particular intermediate regime could be useful, a systematic managed float.
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).
This arrangement, though rather obvious,

has seldom been formalized.
The parameter x calibrates exchange rate flexibility,

and can range from 0 (fixing) to close to 1 (full flexibility).
Thus one can have monetary independence

+ exchange rate stability.
212
Systematic managed floating
refutes the corners hypothesis,

but without capital controls,
without violating the Impossible Trinity,
and even without giving speculators
a line to shoot at.
what some central banks do anyway.
Attempts at econometric estimation
G.Adler & C.Tovar, 2011, Foreign Exchange Intervention:

A Shield Against Appreciation Winds? IMF WP 11/165.
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):
Turkeys central bank buys lira when it depreciates,

and sells when it is appreciates.
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,
while India & Malaysia took them mostly

in the form of currency appreciation.
more-managed floating Slope

= 1/x
less-managed floating
GS Global ECS Research

215
Renewed inflows in 2010 in Latin America
were reflected mostly as reserve accumulation in Peru,

but as appreciation in Chile & Colombia.
more-managed floating
Slope
= 1/x
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
1980-82: Monetarism (target the money supply)

1984-1997: Fixed exchange rates
(incl. currency boards)
1993-2001: The corners hypothesis
1998-2008: Inflation targeting (+ currency float)
became the new conventional wisdom
Among academic economists
among central bankers
and at the IMF.
IT was in many ways successful.

218
Drawbacks to IT have been revealed
since 2008,
analogously to how the currency crashes of the 1990s revealed the drawbacks of
exchange rate targets.
Two problems with IT:

Neglect of asset bubbles
Neglect of supply & trade shocks.
219
If the exchange rate is not to be the monetary anchor, what is? Cont.
ITs neglect of supply & trade shocks.

Remember the textbook maxim: the exchange rate should accommodate terms of trade shocks.
If IT sets the CPI, it doesnt allow the exchange rate
to rise & fall with the terms of trade.
When the world price of copper exports falls, a CPI target does not allow the currency to
depreciate.
When the world price of imported oil rises,
a literal CPI target says to tighten monetary policy enough to appreciate the currency,
= the opposite of accommodating the adverse trade shock.
220
Nominal GDP Targeting
NGDPT is more robust with respect to

supply shocks & terms of trade shocks,
compared to the alternatives of IT
or exchange rate targets.
And more robust with respect to velocity shocks,
compared to M targets.
The logic holds whether the immediate aim is

disinflation (as in 1980s, and again today
among many EMs & developing countries);
monetary stimulus (as among big Advanced Cs recently);
or just staying the course.
221
Figure 2: When a Nominal GDP Target
Delivers a Better Outcome than IT
Supply shock is split between output & inflation objectives

rather than falling exclusively on output as under IT (at B).
222
Figure 3: When IT Delivers a Better Outcome
than a Nominal GDP Target
if the Aggregate Supply curve is steep

(b is low, relative to a, the weight on the price stability objective)
223
NGDPT for Developing Countries
The proponents of Nominal GDP Targets

have focused on the biggest countries.
But middle-size, middle-income countries

are better candidates.
Why? They suffer bigger supply shocks & trade shocks.
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.
Recommendation: EM/DCs should consider NGDPT

as a serious alternative to IT & exchange rate targeting.
224
.
Mathematical analysis:
Which regime best achieves objectives
of price stability and output stability?
The goal is to minimize a quadratic loss function:
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
But different rules => different outcomes, when shocks hit

Rogoff (1985) & Fischer (1990).
IT & NGDPT both neutralize AD shocks so far as possible.
That leaves AS shocks, u.

NGDP rule dominates IT, if a < (2 + b)b;
Example 1: holds if b>a (AS flat, vs. loss function lines).
Example 2: holds if a = 1 (as in Taylor rule)
and AS slope 1/b < 2.414.
Under these conditions, the economy looks
more like Figure 2 than like Figure 3:
If inflation were not allowed to rise in response to an AS shock, the resulting loss in GDP could be
severe => NGDPT dominates IT.
227
Which regime best achieves objectives of price and output stability? continued
For Kazakhstan, an oil exporter, over the period 1993-2012:

the estimated AS slope is 1.66 and statistically < 2.41.
For India, an oil importer, over the period 1996-2013:

AS slope at the 1-year horizon ranges from .38 to .67.
Each estimate of the slope coefficient is not only > 0 statistically,
but significantly < 2.41.
Here the annual monsoon rain is one important supply shock.
Thus under the assumptions we have made, it is estimated

that Nominal GDP Targeting dominates Inflation Targeting
in terms of achieving the objectives of output & price stability,
at least for these two countries.
Frankel, 2013, Exchange Rate and Monetary Policy for Kazakhstan

in Light of Resource Exports, CID, Harvard.
Bhandari & Frankel, 2014, The Best of Rules and Discretion:
A Case for Nominal GDP Targeting in India, HKS, June.
228
Estimation of AS curve for Kazakhstan
& other oil exporters
Regression of inflation against GDP growth, to estimate Aggregate Supply

for oil-exporting countries Table 4, Frankel (2013), thanks to Gulzar Natarajan
Regression with AD shocks

(partner GDP & military spending)
Country as IVs for GDP Period
Coefficient SE t-stat
1 Iran -3.29 5.14 -0.64 1988-2009
2 Saudi Arabia 3.33 1.98 1.68 1988-2012
3 Nigeria 5.86 6.82 0.86 1988-2012
4 Kazakhstan 1.66 0.75 2.21 1993-2012
Note: For some countries, estimated slope did not come out signific 229
Estimation of AS curve for India
Bhandari & Frankel (2014), Table 1: Estimation

of Supply Curve Slope
1st stage dependent variable: output gap
2nd stage dependent Variable: inflation
surprises (winarm/ginarm/ginrw)
Note: First stage non-IV variables not shown.
Memo: List of variables with brief description
WINGAP & GINGAP: Annual inflation rate
minus expected inflation rate derived from an
ARMA model for WPI inflation & GDP deflator
respectively
GINRW: Annual inflation rate - expected
inflation rate derived from random walk
assumption
OGAP: Output gap. Potential calculated by
passing through HP filter
Aggregate demand instruments:
WG: World annual GDP growth
NREG: Dummy variable = 0 when the program
had not started and the value of ratio of
districts covered when it was operating
Aggregate supply shocks:
OIL (-2): Terms of trade variable calculated as
US$ price of a barrel of oil x USDINR exchange
rate, to get the Rupee value of oil; then
deflated by WPI inflation index to convert to
real terms. Quarterly change in the real value
of oil. 2 quarter lag worked best.
RAINS: Percentage deviation of monsoon rains
from normal.
Std. errors in parentheses

*** p<0.01,
** p<0.05,
* p<0.10
230
Figure 2:
Estimates When a Nominal GDP Target
Suggest:

231
232
Appendix 1:
Rules vs. discretion
Appendix 2:
Are Emerging Markets vulnerable
to a global financial shock?
233
Appendix 1:
Why constrain monetary policy
by a rule?
In the dynamic consistency model (Barro-Gordon, 1982)

discretion leads to a positive bias in inflation.
A credible rule can eliminate that inflation bias.
234
Dynamic inconsistency: The Intuition
Assume governments, if operating under discretion,

choose monetary policy and hence AD
so as to maximize a social function of Y & .
=> Economy is at tangency of AS curve &
one of the social functions indifference curves.
Assume also that the social function centers on > ,
even though this point is unattainable, at least in the long run.
Y Y
Assume W & P setters have rational expectations
=> e (& AS) shifts up if rationally-expected E shifts up
=> e = E = on average.

economy is at point B on average. Inflationary bias: e=E > 0.

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
+ Policy-maker minimizes quadratic loss function:

1 1
(11.54) ( y y ) a( ) 2
2
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.
Binding rules. Commit to rule for a nominal anchor:

1. Price of gold 2. Money growth
3. Exchange rate 4. Nominal GDP
5. CPI 6. GDP deflator 4.
240
Appendix 2:
Are Emerging Markets vulnerable
to a global financial shock?
Boom-bust cycle in EM capital flows

External shocks
Risk off
US interest rates
Which countries withstand shocks
In 2008-09 and previous crises?
In 2013 US taper tantrum?
241
3 waves of capital flows to Emerging Markets:
late 1970s, ended in the intl. debt crisis of 1982-89;

1990-97, ended in East Asia crisis of 1997-98;
and 2003-2008, ended when?
IIF 242
http://www.iif.com/press/press+406.php
The Joseph cycle
Joseph prophesied 7 years of plenty,

with abundant harvests from a full Nile
-- followed by 7 lean years of drought & famine.
The Pharaoh empowered his technocratic official (Joseph) to save grain in the 7 years of plenty,
building up sufficient stockpiles to save the Egyptian people
from starvation during the bad years.
-- a valuable lesson for todays government officials in industrialized & developing countries alike.
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 international debt crisis that began in Mexico

in 1982 was the catalyst for the 7 lean years,
known in Latin America as the lost decade.
The turnaround year, 1989, saw the 1st Brady bond issue.
244
Biblical cycle, cont.
The second cycle of 7 fat years was

the period of record capital flows
to emerging markets in 1990-96.
The 1997 sudden stop in East Asia
was then followed by 7 years of capital drought.
The third cycle of inflows, often identified with

carry trade & BRICs came in 2004-2018
and persisted even through the Global Financial Crisis.
If history repeats, it may be time for a 3rd

sudden stop of capital flows to emerging markets!
245
When implicit volatility is high ( in graph),
capital flows to EMs fall: Risk off (e.g., 2009 GFC)
Kristin Forbes, 2014 http://www.voxeu.org/article/understanding-emerging-

market-turmoil
Notes: Data on private capital flows from IMF's IFS database, Dec. 2013. Capital flows are private financial flows to emerging markets
and developing economies. Volatility index measured by the Chicago Board's VIX or VXO at end of period. 2013 data are estimates.
246
See K.Forbes & F.Warnock (2012), Capital Flow Waves: Surges, Stops, Flight and Retrenchment, J. Int.Ec.
The role of US monetary policy
Low US real interest rates contributed to EM flows

in late 1970s, early 1990s, and early 2000s.
The Volcker tightening of 1980-82 precipitated

the international debt crisis of 1982.
The Fed tightening of 1994 helped precipitate

the Mexican peso crisis of that year.
But the correlation is not always there.
247
The relationship between the Feds interest rate
and EM capital flows does not always hold.

market-turmoil
Notes: Data on private capital flows and policy rates from IMF's IFS database, Dec. 2013 version. Capital flows are private financial 248
flows to emerging markets and developing economies. Policy rates measured at end of period. Data for 2013 are estimates.
After Fed taper talk in May 2013, capital flows to Emerging Markets reversed again.
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?
For past studies of past crises, such as 1997-98,

Early Warning Indicators that worked well include:
Foreign exchange reserves
especially relative to short-term debt;
Currency overvaluation;
Current account deficits.
E.g.,
J. Frankel & A. Rose (1996) "Currency Crashes in Emerging Markets," JIE.
G. Kaminsky, S. Lizondo, & C.Reinhart (1998) Leading Indicators of Currency Crises," IMF Staff Papers.
G. Kaminsky, & C.Reinhart (1999)
J. Frankel & G. Saravelos (2012) Are Leading Indicators Useful for Assessing Country
Vulnerability? Evidence from the 2008-09 Global Financial Crisis. JIE.
252
The variables that show up as the strongest predictors of country crises in the past are:
(i) reserves and (ii) currency overvaluation

0% 10% 20% 30% 40% 50% 60% 70%
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.
More-flexible exchange rates

Higher reserve holdings
Less dollar-denominated debt
More local-currency debt
More equity & FDI
Macro-prudential regulation
Fewer Current Account deficits
Stronger government budgets
254
Foreign exchange reserves are useful
One purpose is dampening appreciation,

thus limiting current account deficits.
Another is the precautionary motive.
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
GDP Change, Q2 2008 to Q2 2009
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
-25% -20% -15% -10% -5% 0% 5% 10%

Which EM countries were hit the hardest
by the taper tantrum of May-June 2013?
Those with big current account deficits,

or with exchange rate overvaluation.
Reserves did not seem to help this time.
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
Or January 2014?

or with exchange rate overvaluation.
Reserves did not seem to help this time.
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
Many EMs learned lessons from the 1980s & 1990s,

and by 2008 were in a stronger position to withstand shocks:
More flexible exchange rates
More fx reserves
Less fx-denominated public debt
Stronger budget positions & Stronger current account positions.
Some backsliding, 2010-2014:

Weaker budgets
Current account deficits
The return of fx-denominated private debt.
A promising direction: macro-prudential regulations

E.g., counter-cyclical loan-to-value ratios for mortgages.
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.
II. Financial Sector Reform

One of the first stages in developing a new monetary system in transition economies was the
development of banking system. At the beginning of the transition period all the post-communist
countries faced the similar challenges concerning banking sector reform. They had to create a
two-tier banking system: a CB and commerce banks. They also faced similar constraints that made
this task quite difficult.
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.
The Government Balance

difference between taxes (revenues) T and expenditures G
Under socialism T and G were directly under the state control. During the early years of
transition two major changes occurred:
SOE w/o plan, reduced output and therefore were unable to pay their expenses
(wages, other inputs, etc.)
In the absence of tax system, govt revenues declined; although govt expenditures
could be shrunk, it was difficult (not to close enterprise since unemployment would
increase, safety net
in transition, pressures on T and G resulted in a budget deficit = T-G
During the early transition there were serious imbalances. Although it improved in mid
and late 1990s, there remain persistent deficits that vary with countries.
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.
Inflation in the Transition Economies
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.
The External Balance

When the demand and supply of foreign exchange is equalized or the market for foreign exchange
is in equilibrium
Imbalance between the export and import of goods and services implies the movement of capital,
which along with investment flows (either thru portfolio investment, loans and grants, or FDI)
implies that an external mechanism may be available for assisting w/ the budget deficit.
For example, during the early years of transition, the devaluation of currencies led to an increase in
exports and financial inflows in terms of loans and grants, and FDI. Although capital inflows are
attractive, they expand the domestic money supply and thus must be controlled by some
sterilization policy
A policy used to counteract over-expansion of money is called sterilization (sales of state securities
by the CB to shrink the money supply)
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
Two key culprits behind emerging markets crises were

Lack of credibility of economic policy
Financial market frictions
but traditional debates on currency regimes focus mainly on
Origin/nature of macro shocks
Independence of monetary policy
276
Lessons of Emerging Markets Crises: Sudden Stops & Contagion
Features of a sudden stop:

Sudden reversals of capital inflows
& current account deficits
Collapses of credit, output &
absorption
Collapses of relative prices & asset
prices
Co-movements in country risk &
domestic asset prices
Systemic, exogenous changes in net
capital inflows
277
Why are emerging markets policies less credible?
Bad government, weak institutions

Good, wise government but facing time inconsistency problems
Exchange-rate-based stabilizations
Monetary/ex. rate policies repeatedly used to redistribute/confiscate wealth
and solve financial collapses
278
Why are financial frictions more relevant for emerging markets?
(Calvo & Mendoza JIE 2000, Calvo 1999)
Severe informational frictions

Weaker incentives to acquire and process country information
Adverse effect of globalization
Markets split: specialists/ uninformed
Information is less useful
Larger signal extraction problems
Contagion can be rational
Short-selling constraints, margin constraints and VAR collateralization
amplify these effects
279
How do Non-credible Policies and Financial Frictions Create a Sudden Stop?
Policy uncertainty acts like a random tax on savings and factor

incomes
Mexicos 1987-94 non-credible currency peg (Mendoza & Uribe
CRCS 2000)
Sudden stops occur when policy uncertainty triggers financial
constraints
Liquidity requirements with liability dollarization (Mendoza, 2002)
Margin calls and trading costs (Mendoza & Smith, 2002)
Sudden stops nested within smoother, more common business cycles
Economies can outgrow sudden stops
Large, unexpected shocks can cause sudden stops
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?
Analysis hardly used money and exchange rates

Real effects of policy uncertainty & credit frictions exist in any currency
regime
Dollarization cannot rule out all financial crises
Dollarization cannot address chronic fiscal & institutional problems
282
In Emerging Markets, it has a lot to do with giving up national currencies.
Remove exchange rate uncertainty

Simplify informational needs
Study Mr. Greenspan only, not him and also De la Rua, Duhalde,
Cavallo, .
Eliminate liability dollarization
Improve contracting environment, weaken financial constraints
(welfare gains can be large, Mendoza JMCB 2001)
Increase demand elasticity for emerging markets assets
Still, voluntary dollarization will not happen
Governments value a currencys power to tax, confiscate and
redistribute wealth
Loss of national symbol, seigniorage, sovereignty & independent
monetary policy
283
If it is a great but unrealistic idea, what else can be done?
Price guarantees for emerging markets

Ex ante (Calvo)
Ex post, direct (Lerrick-Meltzer) or indirect (IMF)
Internationalized financial systems with pre-committed credit lines or
narrow-banking constraints
Enhanced surveillance
Socially costly means to try to do indirectly what dollarization does
directly: tie as tight as possible the policymakers hands
284
Outline: Vulnerability Among Emerging Markets
Boom & bust in EM capital flows

despite differences across countries.
The Joseph cycle.
External shocks (push factors)
Which countries withstand shocks well (pull factors)?

The statistical record of Early Warning Indicators:
In currency crises of the 1980s & 90s;
in GFC of 2008-09;
in 2013 taper tantrum.
Appendices:
EM complaint: Currency wars
The choice of monetary regimes.
285
3 waves of capital flows to Emerging Markets:
late 1970s, ended in the intl. debt crisis of 1982-89;

1990-97, ended in East Asia crisis of 1997-98;
and 2003-2008, ended when?
IIF 286
http://www.iif.com/press/press+406.php
The Joseph cycle
Joseph prophesied 7 years of plenty,

with abundant harvests from a full Nile
-- followed by 7 lean years of drought & famine.
The Pharaoh empowered his technocratic official (Joseph) to save grain in the 7 years of plenty,
building up stockpiles to save the Egyptian people
from starvation during the bad years.
-- a valuable lesson for todays public officials

in advanced & developing countries alike.
287
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 international debt crisis that began in Mexico

in 1982 was the catalyst for the 7 lean years,
known in Latin America as the lost decade.
The turnaround year, 1989, saw the 1st Brady bond issue.
288
The second cycle of 7 fat years was

the period of record capital flows
to emerging markets in 1990-96.
The 1997 sudden stop in East Asia
was then followed by 7 years of capital drought.
The third cycle of inflows, often identified

with BRICs & carry trade came in 2004-2008
and persisted even through the Global Financial Crisis.
Is it time for another sudden stop

of capital flows to emerging markets?
289
The role of US monetary policy
Low US real interest rates contributed to EM flows

in late 1970s, early 1990s, and early 2000s.
The Volcker tightening of 1980-82 precipitated

the international debt crisis of 1982.
The Fed tightening of 1994 helped precipitate

the Mexican peso crisis of that year.
as predicted by Calvo, Leiderman & Reinhart (1993).
290
But the relationship between the Feds interest rate
and EM capital flows does not always hold.
Kristin Forbes, 2014 http://www.voxeu.org/article/understanding-emerging-market-turmoil

Notes: Data on private capital flows and policy rates from IMF's IFS database, Dec. 2013 version. Capital flows are private financial 291
flows to emerging markets and developing economies. Policy rates measured at end of period. Data for 2013 are estimates.
Stronger relationship:
When implicit volatility is high ( in graph),
capital flows to EMs fall: Risk off
2008
GFC

market-turmoil
Notes: Data on private capital flows from IMF's IFS database, Dec. 2013. Capital flows are private financial flows to emerging markets
and developing economies. Volatility index measured by the Chicago Board's VIX or VXO at end of period. 2013 data are estimates.
292
See K.Forbes & F.Warnock (2012), Capital Flow Waves: Surges, Stops, Flight and Retrenchment, J. Int.Ec.
After Fed taper talk in May 2013, capital flows to Emerging Markets reversed again.
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.
Aizenman, Binici & Hutchison,

The Transmission of Federal Reserve
Tapering News to Emerging Financial Markets,
March 2014
www.nber.org/papers/w19980.pdf
We group emerging markets

into those with robust
fundamentals (current account
surpluses, high international
reserves and low external debt)
and those with fragile
fundamentals
and, intriguingly, find that the stronger group was
more adversely exposed to tapering news than the
weaker group. News of tapering coming from
Chairman Bernanke is associated with much larger
exchange rate depreciation, drops in the stock market,
and increases in sovereign CDS spreads of the robust
group compared with the fragile group.
A possible interpretation is that
tapering news had less impact on
countries that received fewer inflows
of funds in the first instance.
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?
In past studies of past crises, incl. 1982, 1994, & 1997-98,

Early Warning Indicators that worked well include:
Foreign exchange reserves
especially relative to short-term debt;
Currency overvaluation (i.e., real appreciation);
Current account deficits.
Composition of capital inflows.
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:
(i) reserves and (ii) currency overvaluation

0% 10% 20% 30% 40% 50% 60% 70%
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.

Less fx-denominated debt
More local-currency debt
More equity & FDI
Fewer Current Account deficits
Less pro-cyclical fiscal policy.
Stronger government budgets in 2003-08 boom.
298
China & other EM countries
built up foreign exchange reserves
Aizenman, Cheung & Ito (2014)

--------------- ----------------
International Reserves Before and After the Global Crisis: Is There No End to Hoarding? NBER WP 20386, Aug.
299
EM borrowers moved from fx-denominated debt to local-currency debt over the last 10 years.
Share of External Debt in LC (Mean of 14 sample countries)
Wenxin Du & Jesse Schreger, Harvard U., Sept. 2014, 300

Sovereign Risk, Currency Risk, & Corporate Balance Sheets, Fig.2, p.19 .
Best and Worst Performing Countries
in Global Financial Crisis of 2008-09-- F&S (2012), Appendix 4
GDP Change, Q2 2008 to Q2 2009
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
-25% -20% -15% -10% -5% 0% 5% 10%

Foreign exchange reserves are useful
One purpose is dampening appreciation in the boom,

thus limiting current account deficits.
Another is the precautionary motive:
Reserves were the best predictor of who

got hit in the 2008 Global Financial Crisis.
Dominguez, Hashimoto & Ito (2012) International Reserves and the Global Financial Crisis, JIE.
Frankel & Saravelos (2012), Are Leading Indicators Useful for Assessing Country Vulnerability?
JIE.
This was the same Warning Indicator that also

had worked in the most studies of earlier crises.
302
Other predictors (besides fx reserves)
of who got into trouble in 2008-09 GFC
Current Account
National Savings
Bank credit growth, vs. bank reserves
Short-term debt / exports
Criteria for trouble: loss of GDP, loss of IP, currency market,

equity market & need to go to the IMF.
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:

or with inflation/exchange rate overvaluation.
Less evidence that reserves helped this time.
Very recent studies:

Eichengreen & Gupta (2014), Tapering Talk: The Impact of Expectations of Reduced Federal
Reserve Security Purchases on Emerging Markets., UCB & World Bank, Jan.
Hill (2014), Exploring Early Warning Indicators for Financial Crises in 2013 & 2014, HKS,
April.
Mishra, Moriyama, NDiaye & Nguyen (2014), Impact of Fed Tapering Announcements on
Emerging Markets, IMF, June.
Aizenman, Cheung, & Ito (2014), International Reserves Before and After the Global Crisis:
Is There No End to Hoarding? NBER WP 20386, Aug.
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.
Mishra, Moriyama, NDiaye & Nguyen,

Impact of Fed Tapering Announcements on Emerging Markets,
306
IMF WP 14/109 June 2
Inflation had also risen in Brazil & Turkey.
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.
Mishra, Moriyama, NDiaye & Nguyen,

Impact of Fed Tapering Announcements on Emerging Markets,
308
IMF WP 14/109 June 2014
Countries with high inflation rates suffered
depreciation & bond yield increases, in the year starting May 2013.
A.Klemm, A.Meie
r & S.Sosa, IMF,
May 2014
Taper Tantrum or Tedium:

How U.S. Interest Rates
Affect Financial Markets
in Emerging Economies
309
Countries hit in April-July, 2013, had experienced
real appreciation
and big capital inflows.
B. Eichengreen & P. Gupta (2013) Tapering Talk: The Impact of Expectations of

310
Reduced Federal Reserve Security Purchases on Emerging Markets, Working Paper.
Countries that held excess fx reserves in 2012 suffered
smaller depreciations in 2013, the taper tantrum year.
Currency Joshua Aizenman, Yin-Wong Cheung &

depreciation Hiro Ito, 2014, International Reserves Before and After
the Global Crisis:
(%, vs. $) Is There No End to Hoarding? NBER WP 20386, Aug.
in 2013
Reserves in excess of what is predicted

by some determinants, estimated for 2010-12.
311
Warning sign: Currency composition,
has continued to shift from fx-denomination
to local currency in the case of public debt,
but has reversed in the case of corporate debt, in some EMs.
Wenxin Du & Jesse Schreger, Harvard U., Sept.17, 2014,

Sovereign Risk, Currency Risk, & Corporate Balance Sheets p.18 312
Conclusion
Many EMs learned lessons from the 1980s & 1990s,

and by 2008 were in a stronger position to withstand shocks:
More fx reserves
Less fx-denominated public debt
Stronger budget positions
Stronger current account positions.
Some backsliding since 2009:

Weaker budgets
Current account deficits
Inflation
The return of fx-denominated private debt.
313
Currency wars
Brazils Finance Minister Guido Mantega

complained in 2010 about Fed easing.
Indias Central Bank Governor Raghuram Rajan

complained in 2014 about Fed tightening.
314
Origin of phrase Currency Wars
Warning from Mantega:

Were in the midst of
an international currency war,
a general weakening of currency. This threatens us because it takes away our competitiveness
(9/27/2010).
I.e., countries everywhere are trying

to push down the value of their currencies,
to gain exports & employment,
a goal that is not globally consistent.
315
Currency wars
must be another way of saying competitive devaluation
a kind of beggar-thy-neighbor policy

to use language of the 1930s,
one motive at Bretton Woods
for fixed exchange rates;
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).
If the macroeconomic situation

is the reverse in Brazil, its central bank
will naturally choose a tight monetary policy (high i ).
Also naturally, capital will flow from the US

to Brazil and will in turn appreciate the Real.
But that is the beauty of floating rates.
317
Rajan complains about Fed tightening.
International monetary cooperation has broken down

The U.S. should worry about the effects of
its policies on the rest of the world, 1/30/14.
Central banks should assess spillover

effects from their own actions
For example, this would mean that while exiting
from unconventional policies, central banks would
pay attention to conditions in emerging markets
[T]he Fed policy statement in January 2014, with no mention
of concern about the emerging market situation, and with
no indication Fed policy would be sensitive to conditions
in those markets sent the probably unintended message
that those markets were on their own. 4/10/2014 (Brookings)
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
II. Choice of exchange rate regime
III. Alternative anchors for monetary policy
321
I. How are EMs different
1. Monetary policy-maker has more need of credibility

a) due to high-inflation histories,
b) absence of credible institutions,
c) or political pressure to monetize big budget deficits.
2. Economy is more exposed to supply shocks

a) such as natural disasters,
b) other weather events,
c) strikes and social unrest,
d) productivity shocks.
3. More exposed to terms of trade shocks

because country tends to be price-taker
a) Volatility in price of export commodity on world markets
b) Volatility in price of imports like oil on world markets.
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.
Most countries are in between,
particularly middle-sized middle-income countries.
Most of these countries should have intermediate exchange rate regimes,

neither firm fixing nor free floating.
They include band & basket arrangements.
324
Distribution of EM exchange rate regimes
The big rise is in the managed float category

Distribution of
Exchange Rate
Regimes in Emerging
Markets, 1980-2011
(percent of total)
}
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.
But Stan Fischer has a good point: giving speculators

a target to shoot at is often a losing proposition (disastrous),
such as the boundary of a declared band.
A particular intermediate regime could be useful,

a systematic sort of managed floating:
A rule could say that for every 1% of Exchange Market Pressure,

the central bank takes x % as an appreciation of the currency
and (1-x) % as an increase in reserves (relative to the monetary base).
This arrangement, tho rather obvious, has seldom been formalized.

The parameter x calibrates exchange rate flexibility,
and can range from 0 (fixing) to close to 1 (full flexibility).
Thus one can have monetary independence
+ exchange rate stability.
326
Systematic managed floating
refutes the corners hypothesis,

but without capital controls,
without violating the Impossible Trinity,
and even without giving speculators
a line to shoot at.
what some central banks do anyway.
Attempts at econometric estimation:
Adler & Tovar, 2011, Foreign Exchange Intervention:

A Shield Against Appreciation Winds? IMF WP 11/165.
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):
Turkeys central bank buys lira when it depreciates,

and sells when it is appreciates.
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,
while India & Malaysia took them mostly

in the form of currency appreciation.
more-managed floating Slope

= 1/x
GS Global ECS Research

329
Renewed inflows to Latin America in 2010
were reflected mostly as reserve accumulation in Peru,

but as appreciation in Chile & Colombia.
more-managed floating
Slope
= 1/x
330
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 IT,

after the currency crises of the late 1990s
pushed them off exchange rate targets.
IT (Inflation Targeting) was in many ways successful.
Two problems with IT:

Neglect of asset bubbles
Neglect of exogenous supply & trade shocks.
Remember the textbook maxim: the exchange rate
should accommodate terms of trade shocks.
If IT targets the CPI, it doesnt allow the exchange rate
to rise & fall with the terms of trade.
When the world price of imported oil rises, a literal CPI target says to tighten monetary policy
enough to appreciate the currency,
the opposite of accommodating the adverse trade shock.
331
NGDPT is more robust with respect to

supply shocks & terms of trade shocks,
compared to the alternative of IT.
The logic holds whether the immediate aim is

Disinflation (as in 1980s, and today among some EMs);
monetary stimulus (as among big ACs recently);
or just staying the course.
332
Figure 2: When a Nominal GDP Target

333
NGDPT for EMs
The proponents of Nominal GDP Targets

have focused on the biggest countries.
But middle-size, middle-income countries

are better candidates.
Why? They suffer bigger supply shocks

& trade shocks.
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.
Conclusion: EMs should consider NGDPT

as a serious alternative to IT & exchange rate targeting.
334
Appendix 3: More indications
of strengthened EM policies after 2001
Less pro-cyclical fiscal policy

Current account surpluses
Ability to predict who got hit

in 2008-09.
335
Correlations between Gov.t Spending & GDP
1960-1999
procyclical
Adapted from Kaminsky, Reinhart & Vegh (2004)
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
Frankel, Vegh & Vuletin (JDE, 2013)
In the last decade,

about 1/3 developing countries
countercyclical
switched to countercyclical fiscal policy:

Negative correlation of G & GDP.
337
337
Developing Countries Used Capital Inflows
to finance CA deficits in 1976-1982 & 1990-97;
but not 2003-08.
1st boom
(recycling
petro-dollars) 3rd boom
(carry trade & BRICs)
stop
(international
debt crisis) 2nd boom stop start
(emerging markets) (Asia
crisis)
start
338
IMF
EM countries used post-2003 inflows
EM countries used post-2003 inflows
to build international reserves
to build foreign exchange reserves
Chairman Ben S. Bernanke, 6th ECB Central Banking Conference,

Frankfurt, Nov.19, 2010, Rebalancing the Global Recovery
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
From IMF WEO: Legacies, Clouds, Uncertainties, October 2014.
341
EMs have had to pay higher interest rates since the taper tantrum of 2013,
but conditions eased a bit after April 2014.
From IMF WEO: Legacies, Clouds, Uncertainties, 342

Asia is still doing pretty well.
From IMF WEO: Legacies, Clouds, Uncertainties, 343
Oct. 2014.
Capital flows recovered after the taper tantrum.
From IMF WEO: Legacies, Clouds, Uncertainties,

Oct. 2014. 344
IMF GDP growth rates
WEO,
Oct.
2014.
345
IMF WEO, Oct.
2014.
346
Stemming the Tide:
Capital Account Regulations in Developing and Emerging
Countries
347
Motivation and Outline
Capital Controls A Structural Change?

Whats new?
What has changed?
Are they here to stay?
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
Traditional neoclassical economics > No room for capital controls

International financial markets allow efficient allocation of resources, transfer of savings
and consumption smoothing
Collateral benefits
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
Capital account liberalization and Washington Consensus in the 1990s

Debt restructuring and innovation on international financial markets lay foundation
Second wave of international capital flows: portfolio flows and short-term time deposits
Short-term capital flows attracted by high interest rates: volatility and external vulnerability
Financial Crises
Countries with capital controls fare better (e.g. Chile, Colombia, China, India, Taiwan,
Malaysia)
353
The 2000s and
the Rebirth of Capital Controls
Despite devastating crises experiences further capital account liberalization

New macroeconomic frameworks
Inflation targeting
Floating exchange rates
Central bank independence
(Reserve accumulation)
Third wave of capital flows: increasingly complex and short-term domestic currency assets
Domestic debt markets
Portfolio equity
Derivatives
Currency (Currency Internationalisation and Carry trade)
New investor classes (e.g. large macro-funds, institutional investors)
354
Capital Flows to
Developing and Emerging Countries
Source: Akyuz, 2016 355

The 2000s and
the Rebirth of Capital Controls
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
Average Capital Controls

All Emerging and Developing Countries
0.52
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
Source: Fernandez et al. 2015 357

Average restrictions on capital inflows
Average Inflow Restrictions

0.50
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
Average Outflow Restrictions

0.54
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
Kevin Gallagher: domestic political conditions

institutional structure and political backing
relatively autonomous finance ministry technocrats with some influence over
the central bank
360
The Rebirth of Capital Controls
Inconsistencies of conventional framework- No other choice

Capital flows immense (financialisation)
Global crisis reveals new forms of external vulnerability and inherent instability of financial
integration
Large exchange rate changes despite reserve accumulation and reduction in original sin
Long-term institutional investors contributed
Changing external environment after the global crisis
Lower external demand and falling commodity prices
361
Effectiveness of Capital Controls
Magud and Reinhard (2007, 2011):

Inflow controls are effective in: making monetary policy more independent; altering the
composition of capital flows; reducing real exchange rate pressures
Inflow controls are ineffective in: reducing the volume of net flows
Outflow controls effective in Malaysia, ineffective everywhere else
Klein (2012)
Permanent measures (walls) more effective than temporary ones (gates)
Capital controls reduce risk of financial crisis and financial fragility
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
Period of capital retrenchment as opportunity?

New vulnerabilities
New actors (e.g. non-financial corporations)
New markets (offshore and onshore)
New banking models (onshore subsidiaries)
Continued monetary and financial structural asymmetries
Investment vs. funding currencies
Dominance of developed country financial institutions, instruments, practices etc.
Permanent, institutionalised, dynamic and comprehensive capital controls to foster domestic

savings (domestic funding)
364
International Macroeconomic Policy: Theory and Evidence from Recent Financial Crises
We study macroeconomic developments: growth, unemployment, consumption,

investment, inflation, trade balances, exchange rates, etc.
Macroeconomics is an international discipline as most economies are not closed but open
to trade in goods, services, labor, capital, technology, information (globalization).
Most countries are small open economies; some (U.S.) are large open economies. The world
economy is interdependent and interconnected thanks to globalization
365
International Macroeconomic Policy
Macroeconomic developments depend on macro policies:

Conventional (the policy rate tool, the money supply) and unconventional monetary
policy such as, ZIRP (Zero Interest Rate Policy), QE (Quantitative Easing), CE (credit
easing), FG (Forward Guidance), Negative Interest Rates, Liquidity Support of Banks and
Non-Banks
Conventional (tax and government spending) and unconventional fiscal policy (bailouts
and backstop of banks, households, corporations and other state guarantees for
economic agents)
366
International Macroeconomic Policy
Macroeconomic developments depend on macro policies:

Exchange rate policies: choice of the exchange rate regime (fixed, flexible, etc.), forex
intervention, capital controls
Supervision and regulation of the banks and other financial sector intermediaries
(capital regulation, liquidity regulation, macro-prudential supervision, counter-cyclical
credit policy)
International economic policies such as coordinated macro policies as well as
international bailouts (by the IMF or the Troika) of countries or bail-in of countries
(coercive restructuring of public and/or external debt)
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
There are many types of financial crises:

Currency crisis when a fixed exchange rate regime collapses or a currency goes into a
free fall
Balance of Payments (BoP) or external debt crisis
Sovereign debt crisis
Banking crisis
Corporate debt crisis
Household debt crisis
Broad financial crisis that combines many elements of the above crises (Argentina 2001
for example)
370
Types of financial crises: liquidity versus solvency crises
Financial Crises can be distinguished into two broad types:

Solvency crises
Liquidity crises
Insolvency: An agent is insolvent when its debt relative to its income is so high that in most
states of the world it will not be able to pay back its debt and the interest on it
(unsustainable debt)
Illiquidity: An agent is solvent but illiquid when its debt is not unsustainable but it has large
amounts of this debt coming to maturity (short term debt) and it is not able to roll it over
(liquidity crisis, rollover/run crisis)
371
Liquidity versus Solvency Crises
Many combinations of liquidity/illiquidity and solvency/insolvency

Illiquidity can lead to insolvency as illiquidity can trigger default
Illiquidity can be resolved via:
Domestic or international lender of last resort support (bailouts) to stop rollover/run
crises
Orderly but coercive restructuring (maturity extension) of debts (bail-in of creditors
policies)
Insolvency is resolved via:
Orderly debt restructuring before default
Disorderly debt restructuring (default)
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
Known Known: Either Clinton or Trump will win the election

Known Unknown: Which one of the two will win the Presidency? What would the policies of
Trump be?
Unknown unknown: Could something extreme (health scare, a serious scandal) force Clinton
to drop out of the race?
375
Known Unknown: Economy, Fed and exit from ZIRP
Will economic growth finally accelerate above potential?

Will wage and price inflation remain contained or accelerate?
Is the US in a secular stagnation with low potential growth?
What is the level of NAIRU (structural unemployment rate)?
Will TPP be agreed and passed by Congress?
376
Known Unknown: Fed Exit from ZIRP (Zero Interest Policy Rate)
When will the Fed hike again?

In November 2016
In December 2016
In 2017
When will the Fed finish normalizing the policy rate to a neutral level and what this level will
be (2% or 3% or 4%)?
One year after starting (as in the 1994-1995 cycle)
Two years after starting (as in the 2004-2006 cycle)
Three years after starting
More than three years after starting
377
Known Unknown: U.S. Fall Fiscal Fistfights
Three fiscal known unknowns in 2017 in the U.S.:

Which will be the fiscal policies of Clinton or Trump?
Will Republicans start another fight on the debt ceiling in 2017 as in 2013?
Continuation of the spending sequester or agreement to replace it with something else
post 2017?
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
U.S. economic, political, monetary and fiscal uncertainties

Prospects for growth in developed markets (DM: US, Europe, Japan, etc.) and emerging
markets (EM)
Will DM return to strong growth or will the recovery remain anemic and sub-par?
Is the slowdown in EM cyclical or structural?
Will some EM experience a full crisis and which ones are most at risk?
China: hard or soft or bumpy landing?
Will oil/commodity prices go higher or lower?
380
Current Known Unknowns:
Brexit and EU-disintegration
Will the UK truly exit the EU or eventually back-pedal?

Which deal between UK and EU if Brexit occurs? How much of a loss of market access for
the UK?
Will the EU/Eurozone continue to integrate or will gradually dis-integrate over time?
Which are the main political risks in the EU: Italy, Spain, Portugal, Greece, France, Germany?
Will Germany accept greater EZ integration and risk sharing or will bailout fatigue dominate?
Will the migration crisis be contained or widen so as to threaten the free borders within the
EU (the Schengen agreement)?
381
in the Global Economy: Eurozone
Will the recovery of growth in the Eurozone be robust or weak/anemic/uneven?

Is the EZ still at risk of deflation?
Will the Italian government survive?
Will the ECB do more QE and when?
Will EZ fiscal policy become more flexible?
Will structural reforms accelerate and where?
Will the Euro rise or fall?
382
in the Global Economy: Japan
Will Abenomics work in Japan?

Stronger growth and inflation increase or relapse?
Will structural reforms and trade liberalization be implemented including TPP?
When will the VAT tax be increased?
Will the BoJ do additional QE in 2016-17 and go more negative with it policy rates?
What is the risk of a public debt crisis in the next few years?
Will the Yen weaken and equities rally?
383
in the Global Economy: China
Will China experience a soft landing or a hard landing or a bumpy?

Will China rebalance growth away from too much savings, investment and exports towards
private consumption and labor intensive growth?
Which structural reforms will be implemented in 2016-17?
Will China do another round of policy easing this year as growth still looks fragile?
Will the RMB depreciate further or not?
Will the stock market fall further sharply?
384
in the Global Economy: EM
Is the recent slowdown of EM cyclical or structural? What are its causes?

Will financial pressures intensify to the point of a crisis in some EM or will they diminish?
Which EM are most at risk and why?
What policy options are available for these EM at risk?
What are the medium term prospects for the BRICS and other EM?
Why was Brexit a non-event for EM markets?
385
in the World: Geopolitical Risks
US electoral risk: the Trump uncertainty

Will the Russia-Ukraine conflict escalate or not?
Syria-Iraq-ISIS: further destabilization or stabilization?
Political risks in Europe
Asian territorial issues (as in the case of Japan-China dispute on some islands)
Geo-political implications of the rise of China: peaceful rise?
Which other unknown unknowns (like a 9/11 event or other terrorist attacks)?
Will markets keep on ignoring geopolitical risks?
Populist backlash against globalization, trade, migration, supra-national authorities,
technological disruption
Rise of income/wealth inequality feeds populism
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
Demographics: ageing in DM and EM

High debt ratios that slow spending
Fall in corporate capital spending (global investment slump)
Hysteresis: the cycle affects the trend
Rise in income/wealth inequality
Slow structural reforms
Persistent global savings glut
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
Technological pessimism (Gordon)

Ongoing deleveraging (Rogoff)
Lag between innovations and their spread from tech to other sectors (B2B, B2C)
Mismeasurement of productivity as many goods/services/apps are free and as true prices of
software is not properly measured
Firms that shed work after the GFC are ramping up hiring now for a while
Low skills and human capital of many workers who are not prepared for this globalized
digital economy
392
The global economy after the global financial crisis (GFC)
The economic recovery after the GFC was two-speed:

Anemic, sub-par, below trend in DM (US, EZ, UK, Japan): U-shaped
Strong with return to potential or above trend in most EM: V-shaped
Why V-shaped in EM?
Less balance sheet problems of too much private and public debts. Cleanup after EM
crises of the 1990s
Higher potential growth (5% in EM vs 1-2% in DM)
More room for policy response
393
Why U-shaped Recovery in DM?
The 2008-09 crisis was not a plain vanilla recession

It was a recession caused by a financial crisis. And a financial crisis caused initially by too
much debt and leverage in the private sector (households, banks and some corporates); and
then during the crisis by a surge in public debt and deficits
History and theory suggests that recovery from balance sheet crises is anemic for up to a
decade: you need to spend less and save more (dissave less) to reduce debt and leverage
over time. Thus, an anemic recovery.
Actually, a double dip recession in some DM (EZ, UK, Japan)
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
Growth versus austerity debate

Front load fiscal austerity (as in EZ and UK) or back load it (US, Japan)?
Be very aggressive in monetary easing (US and Japan) or less aggressive (UK, EZ)?
Bailout banks and recapitalize them fast (US) or go slow (EZ, UK)?
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
In 2010-2012 slow, anemic growth in DM (U-shaped), strong growth in EM (V-shaped)

In 2013-16:
Signs of somewhat stronger growth in DM (US, UK, less so in EZ and Japan)
Sharp slowdown of growth in EM and financial pressures on EM markets
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?
Deleveraging not over as debt ratios remain high

Slow structural reforms
Risk of a secular stagnation
Easy monetary policies are becoming less effective as asset reflation may run out of steam
Lack of proper fiscal policy
Policy, political and regulatory uncertainties
403
DM outlook
Differential in growth rates (US/UK versus EZ/Japan)

Inflation below 2% target in DM given still slack in goods and labor markets
But inflation weaker in EZ and Japan relative to US/UK given differential growth recovery
Risk of asset/credit inflation/bubbles?
Exit from zero rates faster in US than in EZ/Japan/UK where QE will continue
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?
Why slowdown now then?

2nd generation reforms did not occur (micro ones that increase competition and
productivity)
Move away from market oriented policies towards state capitalism
Some laxity in monetary and fiscal policy as liquidity was abundant, interest rates too low
and credit excesses
End of luck as:
China is slowing and becoming less resource oriented
The commodity super-cycle is over
However, gradually the Fed is exiting 0% rates. US bond yields up from 1.6% to 2.9%
after May 2013 taper tantrum
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?
But the weaker EM have some negative risks

Ugly policy dilemma:
If you tighten monetary policy to avoid currency free fall and inflation, you kill growth
and damage banks/corporations. So tight money is not credible.
If you loosen monetary policy to boost growth, there is the risk of an inflationary free
fall of the currency and risk that foreigners will not finance your external deficit. If you
thus loosen monetary policy you may lose the nominal anchor of the economy and thus
cause a free fall
So damned if you do and damned if you dont.
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
Medium term positive trends in EM:

Urbanization
Industrialization
Population growth
Per capita income growth
Rise of middle classes and consumer society
A larger share of global GDP and growth in EM
High potential growth given by:
Demographic dividend (high population growth)
2nd generation reforms will boost competition and productivity
Ability to absorb existing and new technologies developed in DM
Technological innovation in some EM (Korea, China, India, etc)
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
U.S. economy is in a tentative improvement growth acceleration

After a weak Q1 and Q2 (1% growth), Q3 seems stronger (2%+)
Latest data on GDP, labor market, consumption, investment, net exports are better but
mixed
Unemployment rate falling because of fall in labor force participation rate and stronger job
creation
Fiscal drag is more modest now
The rise in long rates in 2013 given taper talk crimped growth of interest sensitive sectors
(housing, capex) but in 2014-16 long rates have fallen. Why?
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
Structural reforms are not occurring

Gridlock in Congress and partisanship
Electoral risks
Some households and young are still fragile income-wise and debt-wise
Could inflation rear its ugly head?
Implications of the rise in inequality
Risk of secular stagnation and why?
Can economy sustain the rise in short & long rates as the Fed exits & debt ratios are still
high?
Risk of credit/asset bubbles as Fed exit is slow. Will macro-pru work?
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
EZ tail risks are lower today thanks to:

Draghis whatever it takes
OMT program
ESM program on top of EFSF and EFSM
Beginning of a banking and fiscal union
Start of ECB QE in 2015 and then NIRP
Germany realizing that EZ is also a political project that requires patience: avoid Grexit
Austerity and reforms supported by bailout funds, both fiscal and monetary (ECB)
418
Some Positives in the EZ Today
Return to growth even if recovery is anemic/uneven

ECBs QE, NIRP and Credit Easing; lower euro, lower long rates, higher stock prices; lower oil
price
A lot of fiscal adjustment is done and less fiscal drag ahead. EU accepted fiscal flexibility
Beginning of structural reforms in periphery
Internal devaluation (fall in Unit Labor Costs to increase competitiveness) in some periphery
Austerity/reforms in exchange of liquidity and bailout funds holding politically.
419
The Negatives in the EZ
Low potential growth given slow reforms

Recovery after recession is fragile/weak/uneven.
Public and private debts are still high and rising. Debt sustainability issue
Loss of competitiveness has not been fully reversed. Improvement in trade balances is partly
cyclical (recession)
Still recovery of credit after credit crunch
Still fiscal drag even if if diminished
420
The Negatives in the EZ
EZ is still at risk of deflation

A monetary union requires a banking, fiscal, economic and political union to be viable in the long
run
Some limited progress on the banking union
Austerity fatigue in the periphery and bailout fatigue in the core
Political risks in the core and periphery are high
ECB only game in town as fiscal policy is constrained
Brexit contagion to EU integration
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
Abenomics has partially worked:

Deflation ending
Growth picking up
Yen weaker and stock market stronger
Open issues:
Will structural reforms and trade liberalization that increase potential growth be
implemented faster?
The rise of the consumption tax in 2014 led to Q2 negative growth; now the 2017 hike
has been delayed
Is Japans public debt sustainable in the long run?
Will the BoJ increase QE and/or do more NIRP this year or in 2017?
423
China: Hard landing or soft landing?
Will China experience a soft landing or hard landing or a bumpy/rough landing?

Chinas growth is unbalanced/unsustainable: too much savings, investment & exports; too
little consumption
Will the structural reforms be implemented fast enough to rebalance growth?
Reforms are slower than optimal and desirable as leadership is divided and resistance to
change
Will the stock market crash again?
Will the RMB sharply depreciate?
Growth may slow down to 6% in 2016 and 5% by the end of the decade given lower trend
growth
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
Oil prices are low today given the shale revolution.

But turmoil in the Middle East (the Syria and Iraq security situation; the Arab Spring;
tensions between Israel and its neighbors) could affect oil prices if the fear premium rises
following threats to supply.
The Middle East is an arc of instability that goes from the Maghreb all the way to Af-Pak.
The Middle East and oil prices have been a major source of geo-political tension on global
markets.
Previous US and global recessions have been associated with stagflationary oil price shocks
But so far markets have ignored the geopolitical risks in the Middle East? Why? Will this
change or not?
What is the outlook for oil prices? Will they remain low?
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)
Background on US equity markets in the 2000-2015 period:

The U.S. and global economic slowdown in 2001 led to a sharp slowdown of earnings and
underperformance of equity markets (on top of the dotcom bust and Nasdaq collapse in 2000).
Equity markets also underperformed in 2002 as the stock market rally after the 9/11 drop was
excessive and based on overoptimistic expectations of growth.
Stock markets slumped again in the first quarter of 2003 as the concerns about a war with Iraq led
to renewed risk aversion.
But they then recovered sharply after the war in 2003 as markets started to expect a sustained
economic recovery and a sharp pick-up in profits and earnings.
But stock indexes remained mostly flat on average in 2004 and even in 2005 and 2006 (with only a
modest uptrend since 2004) even if corporate balance sheets have improved sharply (with debt
de-leveraging) and earnings growth has been sustained in 2004-2006.
Equity markets in the US and abroad rallied sharply in 2006-2007
Bear market in equities starting with the financial turmoil in the fall of 2007
Bottom of the bear market in March 2009 and then rapid recovery through 2014 with some
episodes of risk off followed again by risk on.
In 2013 sharp rally of US equities that continued at a slower pace in 2014.
Is the US stock market overvalued? Will a correction occur or will it continue to trend up and by
how much in 2016 and beyond?
How much contagion from China as in the summer of 2015 when first correction since 2011
occurred? Uncertain outlook for earnings in 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
Fiscal stimulus package in 2008 as the economy entered a recession

As second $900 billion fiscal stimulus package legislated in early 2009
Deficit for 2009 rose to be $1.4 trillion but is now much lower ($450 bn) or 3% of GDP in
2015
Fiscal path deficit and debt - is clearly unsustainable as over the next decade deficits will
rise again unless entitlement spending is reformed (Social Security and Medicare)
Difficult issue of when to exit from the fiscal stimulus. The U.S. postponed till 2012 but
serious fiscal drag in 2012-13 given spending cuts/sequester and rise in taxes
2013 showdown on government shutdown and debt ceiling
Will fiscal fights in Congress resume in fall 2015?
Or will another compromise on the sequester be achieved for 2016 and beyond?
442
Global current account imbalances
Are the global current account imbalances (still large deficit in the US and fragile EM, large
surpluses in Europe, China and some emerging market economies) sustainable over time?
Is the US current account deficit and external debt accumulation sustainable? It is shrinking
but maybe too slowly?
Will the adjustment of global imbalances be orderly or disorderly?
Is the global current account adjustment to asymmetric as deficit countries need to retrench
while surplus countries arent reducing their surpluses? Is this deflationary for the world?
How will the major currencies ($, 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
Why did the subprime crisis lead to a wider credit crunch?

Was the crisis due to a liquidity crunch or a credit crunch/solvency crisis?
What is the risk of a another systemic crisis and what factors trigger one?
What causes asset bubbles? What causes housing bubbles and bust?
How should monetary policy react to asset bubbles and asset bubbles bursting? Should
central banks address bubbles with a rise in interest rates or via macro-prudential
supervision and regulation?
Should we worry about deflation or inflation?
How will central bank exit unconventional monetary policies (ZIRP, QE, CE, FG, NDR)?
What is the risk of sovereign debt crises in developed markets?
Why is income and wealth inequality rising and what is the impact of it?
Are advanced economies at risk of secular stagnation and why?
445
Some of the cutting edge issues in
international macro policy debates
Should we worry about stagflation or stag-deflation?

Are global external imbalances sustainable or not, and for how long?
Are twin fiscal and current account deficits sustainable in DM and EM?
Should we worry about asset protectionism and restrictions to FDI?
Should we worry about capital controls on inflows and outflows?
Should we worry about resource protectionism?
What is the future of offshore outsourcing?
Is the trade liberalization Doha round as dead as Dodo?
Is free trade compatible with flexible exchange rates or does greater trade integration
require managed or pegged exchange rates?
Is globalization at risk of reversal?
Should we be optimist or pessimist about the pace of future technological innovation?
Will robots/automation replace most jobs?
What explains the rise in inequality and what can we do about it?
446
Are highly-leveraged institutions and hedge funds a source of systemic risk?

What is the risk of new asset and credit bubbles?
Is housing frothy and bubbly in some economies?
Will macro-pru be effective in ensuring financial stability or not?
Is offshore outsourcing a threat or a benefit for the global economy?
Will the BRICs dominate the world economy in the next decades?
Is the balance sheet approach the appropriate framework for thinking about financial crises in
emerging economies?
Are crises due to fundamentals or self-fulfilling liquidity runs?
What explains sudden stops and reversals of capital inflows?
What explains the joint eruption of currency, sovereign debt, systemic banking and systemic
corporate crises?
447
What is the appropriate form of PSI/bail-in/burden-sharing in crisis resolution?

Do we need an international lender of last resort (ILOR)?
What explains international contagion?
How to deal with liability dollarization and original sin?
Do we need an international bankruptcy regime for sovereigns?
What is the most desirable sovereign debt restructuring mechanism?
Do emerging markets suffer of fear of floating and if so why?
Is unilateral dollarization the way of the future?
Are monetary unions feasible without broader banking, fiscal, economic and political
unions?
Is sterilization of excessive capital inflows feasible and desirable?
What is the desirable reform of the international financial architecture?
Will the US dollar remain the main global reserve currency?
Will the Chinese RMB emerge as a major global currency?
448
Sources of International
Macroeconomic Interdependence
among Economies
Macroeconomics is international given the increasing economic interdependence

among countries and the increased globalization of trade and finance.
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
Assets/Liabilities traded internationally

Stocks
Bonds
Derivative instruments (in the GFC)
International financial markets/intermediaries:
Banks
Capital markets (stock/bond/money markets)
Foreign exchange markets
Commodities markets
450
Interdependence channels via
common shocks and FDI/MNCs
Common sectoral/external shocks

Common oil and commodity shocks
Tech sector technology shock in the mid 1990s and bust in 2000-2001
Housing bubbles in the US and other countries; and their bust in 2007-09
Global credit crunch
Foreign Direct Investment (FDI)/ Multinational Corporations (MNCs):

Real investment (FDI, M&A)
Output/production location decisions
451
Interdependence via Policy Links
Domestic effects of macro policies

International effects of domestic policies if a country is large (US, Europe, Japan)
Global financial contagion of 2008-2009
Financial contagion from China risks in 2015
International effects of domestic policies even if a country is small (international contagion):
Mexico Tequila effect in 1995
The Asian fever/flu
The Russian virus (contagion to emerging markets Brazil, LatAm - and advanced
markets LTCM & US capital markets)
The Turkish influenza in 2001
Greece, Iceland, Cyprus in 2010-12
Grexit risk in 2015
452
Many Financial Crises in Emerging Markets and G7 Economies in the last two decades
Currency/Financial Crises in Emerging Markets:

1980s debt crisis in Latin America
Mexico, East Asia, Russia, Brazil in the 1990s;
Turkey and Argentina in 2001; Uruguay in 2002; Brazil mini-crisis in 2002; Dominican
Republic in 2003
Market turmoil (mini-crisis) in EMs in May-June 2006
Massive contagion of US financial crisis of 2008-2009 to emerging markets economies
markets and economic growth. Avoidance of outright financial crises given stronger
fundamentals
EM mini crisis of 2013-15? Will it worsen? Is China at risk of a hard landing?
453
Crises and financial stresses in Advanced/G7 Economies
S&L crisis in US in early 1990s

Corporate/Banking crisis in Japan in 1990s after bursting of the 1980s asset price bubble
European Monetary System (EMS) currency crisis in Europe in 1992-93 (Italy, UK, France,
Sweden)
Banking crisis in Finland and Sweden in early 1990s
Bond market crash in the US in 1994 as the Fed unexpectedly tightened monetary policy.
Sharp fall of the value of the US dollar in 1994-1995
LTCM crisis in 1998 and seizure of U.S. capital markets
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
The oil shock in 2000 contributing to the global slowdown

Fed tightening of monetary policy between mid 1999 and mid 2000 as the economy was
overheating.
US slowdown and recession and global slowdown in 2001; it started before 9/11 but was
exacerbated by it.
Third and final stage of EMU (Euro introduction) started in 2002.
A de facto Bretton Woods II regime since 2001 as China and Asia effectively pegged their
exchange rates to the U.S. dollar through aggressive foreign exchange intervention.
Tentative U.S./global recovery in early 2002 that slowed down in the spring and in the fall. Slow
growth in H1-2003 (given Iraq war uncertainty); U.S. and global recovery in second half of 2003
and Q1:2004 but with poor job growth (jobless recovery). Higher US and global growth in 2005-
2006
Bursting of the US housing bubble and a housing bust since mid 2006. Sub-prime mortgage crisis in
the US (2007)
US and global economic and financial crisis of 2008-2009
Anemic, sub-par, below trend U-shaped recovery in DM in 2010-2013
Double dip recession in Eurozone, UK and Japan in 2011-2012
Stronger recovery in some advanced economies in 2015. EZ recovery
Summer 2015 financial turmoil given China hard landing risks
Risk of new asset/credit bubbles as exit from ZIRP is too slow?
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
Argentina currency and financial crisis and default of 2001-2002

Financial/currency crisis in Uruguay in 2002
Risk of a financial crisis in Brazil as October 2002 elections were looming. Financial recovery after
the election. Weak economic performance of Latin America in 2003 with growth recovery in 2004-
2005.
Accession of 10 emerging markets (mostly transition economies) to the European Union in 2004.
Rapid growth of emerging market economies in 2004-2006 on the back of macro/financial reforms
and benign global conditions (high global growth, high commodity prices, low G7 interest rates).
International investors rediscover emerging markets.
Boom in commodity prices exported by EMs.
2006-2007: Africa as the new EMs growth story and asset class?
Turmoil in EM financial markets in May-June 2006, especially for countries with external
vulnerabilities
Bubbly equity markets in EM especially in China, India and Gulf states
Contagion of the US financial crisis to emerging market economies in 2008-2009.
Strong V-shaped recovery of EM in 2010-2012 given stronger fundamentals
Slowdown and financial pressures in EM starting in 2013 and into 2014-15:slowdown of China, end
of commodity super-cycle, Fed talk about tapering, policies reducing potential growth
Risks of financial crises in fragile EM in 2015-2016?
459
Ulysses and the Sirens:
Political and Technical Rationality in Latin America
Javier Santiso
Chief Economist for Latin America and Emerging Markets

Economic Research Department
BBVA
Washington, DC, March 2005

Inter-American Development Bank
460
A POLICY-ORIENTATED RESEARCH PROJECT
Research Project:
There are two main purposes to this study:
1. To contribute to the evaluation of the number of institutions

that promote the application of knowledge to economic policies;
2. To show, parting from study cases, how technical and political

rationality are articulated.
Policy-issues:
Technopols in Emerging Democracies: Strengthening the Economic

and Technical Capacity of Parliaments.
Brain-Gain for Emerging Democracies: Research Fellows based in

Latin American Think-Tanks.
461
TECHNOPOLS AS INSTITUTIONAL MASTS
In dealing with the multiple and complex

problems of development, we have learnt
that we must be deaf, like Ulysses, to the
seductive chant of the unique paradigm.
Albert Hirschman
462
1. Technopols in Latin America: Cognitive Mapping of Institutional Masts
- Private Actors: International vs National

- Public Actors: Government, Agencies and Congresses
- Think-Tanks and Universities
- International Organizations
2. The Interactions Between Experts and Politics in Emerging Democracies.
- Enter the Matrix: The case of Per

- The Reform of Pension Funds: Institutions and Processes.
- Fiscal Reform: Institutions and Processes.
463
A COGNITIVE MAPPING OF
LATIN AMERICAN TECHNOPOLS
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
The presence of these institutions contributes to the democratic governance promoting

higher deliberative quality in public space.
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
The following points of analysis are contemplated in this sense:
What is the inherent capacity of cognitive institutions ?
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 inherent technical capacity in the Legislative institutions in terms of

economic policies ?
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
Research Olympics 2004
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
LatinFinance sent questionnaires to top

portfolio managers and institutional
Latin Finance Research Olympics 2004 investors in Latin American debt and
Overakk Rank Bank
equity instruments.
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
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472
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Standard Chartered
Caja Madrid
UBS
BNP Paribas
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ING
Bear Stearns
HSBC
JP Morgan
Banco Votorantim
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Bradesco
Number of Latin American Research Analysts based in Latam in 2005
BBVA
SCH
473
Latin American Research Analysts in 2005

(% based in Latam)
100,00%
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80,00%
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474
BANKS: WALL STREET IS WATCHING YOU BUT NOT EVERYBODY
Country coverage in 2005

(% of research teams covering the country - sample: 17)
100%
90%
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
Ratio of Analysts by Country

(Latin American Research Teams in 2005)
14,00
12,00
10,00
8,00
6,00
4,00
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476
PUBLIC ACTORS: GOVERNMENT AND NATIONAL TECHNOPOLS
The research departments of government institutions (Central Bank, Ministry of Economy

and all types of public national organisms) that process, produce and spread expert
knowledge on economic policies
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
Brazilian Congress - Lower House:

Number of analysts in each Area
18
16 17
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
Area Name Area Number of consultors

I I
Constitutional Law, Electoral, Municipal, Administrative, Legislative Process and Judiciary 17
II II
Civil Law and Procedural Law, Penal and Procedural Penal, Family, Author, Successions, 11 International
Private
III Tributary Law, Taxation III 10
IV Public Finance IV 5
V Labor Law and Procedural Labor V 11
VI Agrarian Law and Land Policy VI 4
VII Financial System, Comercial Law, Economic, Consumer Rights VII 10
VIII Public Administration VIII 10
IX Politics and Economic Planning, Economic Development, International Economics IX 8
X Agricultural and Rural Politics X 7
XI Environment and Environmental Law, Territorial Organization, Urban and Regional XI 8
Development
XII Mineral, Hydro and Energetic Resources XII 6
XIII Urban Development, Traffic and Transportation XIII 7
XIV Social Communication, Informatics, Telecommunications, Postal System, Science XIV 6
and Technology
XV Education, Culture, Sports, Science and Technology XV 10
XVI Public Health, Sanitarism XVI 6
XVII Security and National Defense XVII 5
XVIII International Public Law, International Relations XVIII 4
XIX Political Science, Sociological Science, History and International Relations XIX 7
XX Writing and Parliamentary Speech XX 15
XI Social Security, and Social Security Law XI 7
Total= 174
479
INTERNATIONAL ORGANIZATIONS AS TECHNOPOLS
Technopols on Latin America: Multilaterals
Argentina: INTAL-IADB http://www.iadb.org/intal/

Chile: ECLAC http://www.eclac.org/
Costa Rica: FLACSO http://www.flacso.org/
Mxico: CEMLA http://www.cemla.org/
Venezuela: CAF http://www.caf.com/
Venezuela: SELA http://www.sela.org/
Venezuela: CLAD http://www.clad.org.ve/
United States: IADB http://www.iadb.org/
United States: The World Bank http://www.worldbank.org/
United States: IMF http://www.imf.org/
480
THINK-TANKS IN LATIN AMERICA
Sample
Argentina: FIEL http://www.fiel.org/

Argentina: Fundacin Mediterrnea http://www.ieral.org/
Argentina: CIPPIEC http://www.cippec.org/
Argentina: CEDI http://www.fgys.org/
Argentina: CADAL http://www.cadal.org/
Argentina: CEI /Torcuato http://www.utdt.edu/cei/
Argentina: IADE http://www.iade.org.ar/
Argentina: CENIT http://www.fund-cenit.org.ar/
Argentina: CEMA http://www.cema.edu.ar/
Argentina: Estudio Broda http://www.estudiobroda.com.ar/
Argentina: Fundacin Capital http://www.fcapital.com.ar/
Argentina: Ecolatina http://www.ecolatina.com/
Brazil: CEBRAP http://www.cebrap.org.br/
Brazil: AC Pastore http://www.acpastore.com/
Brazil: MBAssociados http://mbassociados.com.br/
Brazil: Tendencias http://ww2.tendencias.inf.br/
Brazil: Fernand Braudel Institute http://www.braudel.org.br/
Brazil: FIPE http://www.fipe.com.br/
Brazil: IBRE / FGV http://www.ibre.fgv.br/
481
THINK-TANKS IN LATIN AMERICA
Colombia: Fedesarrollo http://www.fedesarrollo.org/

Colombia: CEDE http://www.uniandes.edu.co/
Chile: CIEPLAN http://www.cieplan.cl/
Chile: Instituto Libertad y Desarrollo http://www.lyd.cl/
Chile: CEP http://www.cepchile.cl/
Chile: ILADES http://www.ilades.cl/
Per: IPE http://www.ipeportal.org/
Per: CIUP http://www.up.edu.pe/ciup/
Per: IPE http://www.iep.org.pe/
Per: Apoyo http://www.apoyo.com/
Per: GRADE http://www.grade.org.pe/
Mxico: CIDAC http://www.cidac.org/
Mxico: CIDE http://www.cide.edu/
Mxico: CIE / ITAM http://cie.itam.mx/
Uruguay: CERES http://www.ceres-uy.org/
Uruguay: CLAEH http://www.claeh.org.uy/
482
THINK-TANKS ON LATIN AMERICA OUTSIDE THE REGION
FOCAL (CANADA):
Based in Ottawa and founded in 1990. http://www.focal.ca/
Fosters informed analysis and debate on North and South American social, political and economic
issues.
It has a full time staff of approximately 15.
THE INTER-AMERICAN DIALOGUE (USA):
Based in Washington and founded in 1983.
Engages public and private leaders throughout North and South America in an effort to discuss key
hemispheric problems and opportunities.
It has a full time staff of approximately 29.
483
Council on Foreign Affairs Latin American Studies Program:
Based in New York; 1 analyst on Latam; http://www.cfr.org/latinamerica/
The Heritage Foundation:
Based in Washington; founded in 1973; 3 analysts on Latam. http://www.heritage.org/
American Enterprise Institute:
Based in Washington; founded in 1943; 1 analyst on Latam; http://www.aei.org/
Americas Society:
Based in New York and Washington; founded in 1965 by David Rockefeller; 2 experts on Latin America; http://www.americas-society.org/
The Brookings Institution:
Based in Washington; founded in 1916; 5 experts on Latam; http://www.brook.edu/
The Institute for International Economics:
Based in Washington; founded in 1981; 3 experts on Latam; http://www.iie.com/
Rand - Latin American Policy Research Program:
Based in Santa Monica; founded in 1946; 11 experts Latam, http://www.rand.org/nsrd/latinamerica/staff.html
Cato Institute:
Based in Washington; founded in 1977; 3 experts on Latam ; http://www.cato.org/
Center for Strategic and International Studies (CSIS)
Based in Washington; founded in 1965; 7 experts on Latam; http://www.csis.org/
Hoover Institution:
Based in Stanford; foudned in 1959; 6 experts on Latam; http://www.hoover.org/
CIPE
Based in Washington; founded in 1983, 2 experst on Latam; http://www.cipe.org/
Carnegie Endowment for Peace:
Based in Washington; founded in 1910; 5 experts Latam; http://www.carnegieendowment.org/
484
Royal Institute for International Affairs:

Based in London; founded in1920; 5 experts on Latam; http://www.chathamhouse.org.uk/
Oxford Latin American Centre

Based in Oxford; founded in ; 13 experts on Latin America; http://www.lac.ox.ac.uk/
Canning House:
Based in London; founded in 1943; http://www.canninghouse.com/
Real Instituto Elcano:

Based in Madrid; founded in 2003; 2 experts on Latam; http://www.realinstitutoelcano.org/
485
EXPERTS AND POLITICS IN EMERGING DEMOCRACIES
ENTER THE MATRIX: THE CASE OF PER
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 Ministry of Economy and Finance

It is the institution that leads economic policy.
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).
In practice, the formulation of policies, is coordinated through an informal

committee, comprising the Minister of Economy, the Vice minister of Treasury, the
Head of the Advisors Staff and the Economic Studies Manager of the Central Bank.
Once a policy is approved by this committee, the policy is implemented or sent to
Congress for debate and approval.
The Viceministry of Economy, works with 40 employees, approximately, distributed in the

abovementioned departments.
488
THE CENTRAL BANK
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
The Economic Studies Department is responsible for the implementation of monetary policy.
It has 120 employees, 80 of them economists.
The Department has an administrative structure influenced by the financial programming

schemes of the International Monetary Fund. It is organized in five departments: global
analysis sector, external sector, monetary sector, fiscal sector, and real estate sector.
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.
These institutions influence economic policy agendas, through periodical

publications, research, press appearance, or by giving direct or indirect advice to the
government.
Name Web Total employees Total economists/employees Total economists/PhD Level

IPE www.ipe.gob.pe 25 10 2
CIUP www.ciup.gob.pe 70 55 4
GRADE www.grade.org.pe 47 36 3
APOYO www.apoyo.com.pe 65 57 0
Name Web Annual budget (US$) Participation of Private Sector in Budget

IPE www.ipe.gob.pe US$ 300 thousands 100%
CIUP www.ciup.gob.pe na na
GRADE www.grade.org.pe US$800 thousands 100%
APOYO www.apoyo.com.pe US$ 5 millions 100%
494
THINK-TANKS IN PERU: AN INTERNATIONAL COMPARISON
Europe Annual Income Endowment
Real Instituto Elcano 3 M Euros No
CEPR 2.6 M GBP No
USA
Rand Corporation 224 M USD 357 M USD
IIE 7 M USD 150 M USD
CEIP (Carnegie) 19 M USD 174 M USD
The Brookings Institution 33 M USD 217 M USD
Heritage Foundation 42 M USD 102 M USD
The Cato Institute 13 M USD No
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
Instituto Peruano de Economa (IPE)
The Peruvian Institute of Economics (IPE), was created in 1995 as an iniciative of 31

Peruvian firms. It was originally supported by the World Bank, receiving contributions
from the World Bank Institutional Development Fund.
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
The Analysis Group for Development (GRADE) is a non governmental organization,

that carries out investigations on public policy design and implementation.
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).
However, their contribution to the economic policy debate is marginal.
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.
These institutions contribute in a similar way to economic debate, basically through

publications, articles, press appearances, seminars, conferences and interviews.
Bank Web Total analysts Total Phd level Government

Banco de Crdito www.bcp.com.pe 9 0 Yes
Banco Wiese Sudameris www.bws.com.pe 7 0 Yes
BBVA www.bbvabancocontinental.com 3 0 Yes
501
TECHNICAL RATIONALITY AND POLITICAL RATIONALITY:
REFORMS TO PENSION FUNDS AND FISCAL REFORMS
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.
To raise the level of decisional responsibility and institutional transparency, we need to

reinforce the production base and the spread of existing knowledge in open societies, as
well as articulating the shared knowledge network between the State and the
knowledge production centers.
This articulation is key to the perspective of democratic governance. It is even more

relevant in emerging democracies.
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?
Do they have the disposal of internal analysis services?
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
Chief Economist for Latin America and Emerging Markets

Economic Research Department
BBVA
Washington, DC, March 2005

Inter-American Development Bank
508
Fiscal Alchemy?
An International Perspective
Jeffrey Frankel
Seminar on Macroeconomic Policy

Harvard Economics Department
April 28, 2015
509
Fiscal alchemy?
Eric Leeper had it backwards:

"Monetary science, fiscal alchemy" (Jackson Hole, 2010).
It should be Monetary alchemy, fiscal science:
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.
But consider country cases below.
Japan.
Euroland.
Emerging markets.
511
Monetary policy is of course
relatively less powerful at Zero Lower Bound.
even though it is still worth doing,

via channels other than short-term interest rate:
Exchange rate
if particular countries need more stimulus than others;
Expected inflation;
Long-term bonds, equities, and real estate.
Coordination of monetary policy is not especially needed, despite currency wars.
512
How had Keynesian fiscal policy been discredited?
Not lack of knowledge,

nor lack of effectiveness.
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
3) Emerging Market economies
514
(Case 1) Japan
The three arrows of Abenomics
Monetary stimulus (2% inflation target + QQE)
Fiscal policy (?)
Structural reform (?)
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.
Because the 2nd & 3rd arrows havent been fired?
Id say the 2nd was fired in the wrong direction:

Abe went through with the scheduled increase
in the consumption tax taking effect April 1, 2014,
from 5% to 8%.
As many had warned, Japan went back into recession, i.e., growth turned negative for next two
quarters.
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.
Nov. 2012 => April 2014 =>

Abenomics 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
The three arrows of Mario Draghi

(Jackson Hole 8/22/2014)
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.
What about the critique that fiscal policy responded endogenously

(and negatively) to the magnitude of the countries difficulties?
523
The bigger the fiscal contraction, the bigger the GDP loss relative to what had been officially forecast
=> true multipliers > than multipliers that IMF had been using.
Europe: Growth Forecast Errors vs. Fiscal Consolidation Forecasts
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.
Declining GDP outweighed progress on reduction of budget deficits.

200
Public Debt (% GDP)
180
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
Fiscal policy in some EMs

turned from pro-cyclical to countercyclical after 2000,
-- e.g., Chile, India, Malaysia, Korea, China, Botswana --
taking advantage of 2002-08 boom to strengthen their budgets,
and so making fiscal space to moderate the 2008-09 recession.
= the opposite from some Industrialized Countries.
Some major EMs are more vulnerable to the next shock

because they have backslid on cyclicality since 2010,
e.g., Brazil, India, Thailand.
or never did graduate from pro-cyclicality at all,
e.g., Argentina, Venezuela.
527
Correlations between Gov.t Spending & GDP
1960-1999
procyclical
Adapted from Kaminsky, Reinhart & Vegh (2004)
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
Frankel, Vegh & Vuletin (JDE, 2013)
In the last decade,

countercyclical

529
529
530
Appendices
(1) Japans Abenomics
(2) Euroland
(3) Which Emerging Market countries

achieved fiscal counter-cyclicality?
and how?
531
(1) Japans monetary easing weakened the yen, 2012-13
House of Representatives dissolved,

Nov. 2012 => Abenomics
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
Adapted from Frankel, Vegh & Vuletin (JDE, 2013)
In the decade 2000-2009,

DEVELOPING:
43% (or 32 out of 75) countercyclical. The figure was 17% (or 13
out of 75) in 1960-1999. 534
Latest update of Correlation (G, GDP):
Back-sliding among some countries, 2010-2014.
Thanks to Guillermo Vuletin
DEVELOPING: 37% (or 29 out of 76) pursue counter-

535
cyclical fiscal policy.
The correlation for 2000-09 vs. 2010-14
536
Who achieves counter-cyclical fiscal policy?
Countries with good institutions
IQ
On Graduation from Fiscal Procyclicality,

Frankel, Vgh & Vuletin; J.Dev.Economics, 2013.
537
The quality of institutions varies,
not just across countries, but also across time.
1984-2009
Worsened institutions; Improved institutions;

More-cyclical spending. Less-cyclical spending.
Good institutions;
Countercyclical spending
Frankel, Vgh
& Vuletin,2013. 538
How can countries avoid pro-cyclical fiscal policy?
What are good institutions, exactly?
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
DR: Debt Rules
ER: Expenditure
Rules
Compliance
< 50%
International Monetary Fund, 2014 540

To expect countries to comply with the rules during recessions is particularly unrealistic
(and not even necessarily desirable).
Bad times: years when output gap < 0
541
International Monetary Fund, 2014
US official projections were over-optimistic on average.
F & Schreger, 2013

542
Greek official forecasts were always over-optimistic.
F & Schreger, 2013

543
Data from Greeces Stability and Convergence Programs.
German forecasts were also usually too optimistic.
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
For 17 Europeans, the bias is even higher than others, averaging:

0.5% at the 1-year horizon,
1.3% at the 2-year horizon,
2.4% at the 3-year horizon
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,
2nd rule The target is structural:

Deficits allowed only to the extent that
(1) output falls short of trend, in a recession,
(2) or the price of copper is below its trend.
3rd rule The trends are projected by 2 panels

of independent experts, outside the political process.
Result: Chile avoided the pattern of 32 other governments,
where forecasts in booms were biased toward optimism.
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
Edinburgh, 1 June 2012

* The views expressed are those of the author and do not necessarily reflect the position of the ECB.
549
Conceptual Framework
Designing EMU
The response to the crisis
Filling the gaps in economic governance
Toward economic and financial union?
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.
See also ECB Monthly Bulletin July 2012 (forthcoming)
551
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)
Legal basis (Maastricht Treaty)

Art. 101 monetary financing prohibition
Art. 102 prohibited privileged access to governments
Art. 103 (1) no bailout clause
Art. 104c, 109j and protocol annexed in the Treaty outlined the Maastricht criteria
553
Price stability
orientation
of the central bank
ECBs institutional context
Independence
EMU
of the central bank

EMU rests on four fundamental constitutional pillars
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
Source: Yiangou, Glckler, OKeefe (forthcoming)

555
What went wrong (I)? despite early warnings
Weak implementation of fiscal rules

Insufficient monitoring of imbalances
..[T]he access to a Unit labour costs in selected euro area countries, nominal
(index 1998 Q4 = 100, relative to Germany, based on sa data)
large capital market Euro area Germany France Italy Spain
Netherlands Belgium Austria Greece Ireland
may for some time Finland Slovakia Luxembourg Portugal Slovenia
Cyprus Malta
even facilitate the 145 145
financing of economic 140
135
140
135
imbalances. 130 130
(Delors report, 1989) 125 125
120 120
115 115
Low pricing of 110 110
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)
No crisis resolution mechanism

No responsibility for financial stability at euro area level
Contagion channels not adequately understood
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
Financial integration Sovereign-bank interdependence
Financial stability National supervision No monetary financing National fiscal policies
Source: Schoenmaker (2011) Source: Pisani-Ferry

(2012)
Increasing financial fragmentation due to bank sovereign nexus:

also a risk of financial dominance
558
Designing EMU
559
559
Financial sector debt transferred to public sector
Short-term fiscal impact of crisis- general government

debt
Source: Commission Services

560
560
Sovereign spreads on the rise
Spreads compared to 10 yr German Bund, in basis points
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
Increased risk aversion and retrenchment behind national borders
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
Quelle: ECB Financial Integration Report, April 2012

566
Could the ECB break that feedback loop?
In the absence of common supervision, resolution

or fiscal backstop:
Deploy bazooka via the ECB operations?
Unlimited commitments? Yield targets?
Major problems:
Legal prohibition
Incentives
Accountability and democracy
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
Two 3-year operations

(1) 489 bn, 523 counterparties;
(2) 529 bn, 800 counterparties
Exceptionally serious situation in late 2011

panic and complete drying-up of
inter-bank markets;
Dangers of a credit crunch;
perceptions of the inevitability
of a catastrophe
569
569
Impact on money markets
Reduced tensions in money Reduced credit risk

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
Quelle: ECB Bank Lending Survey April 2012

571
Addressing the criticisms
No real help for real economy?

800 banks of which 500 German (i.e. many of those
which are closest to SMEs)
Excessive risks for the Eurosystem balance sheet?

strikt und differentiated risk management framework
loss only through double default
dynamic balance sheet as part of normal central bank
functions (i.e. when intermediation breaks down)
572
The breathing Eurosystem balance sheet
Quelle: ECB, Letzte Daten: 26..Mrz 2012

573
Sowing the seeds of future inflation?
Market-based inflation indicators
euro area (%.)
Different concepts of liquidity
Till now no significant increase
in monetary aggregates
(M3 +3.2% March 2012)
Inflation expectations securely
anchored
Eurosystem can re-absorb
liquidity (e.g. via minimum
reserve requirements)
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
Designing EMU
575
575
2. A robust rescue mechanism
Primary Supportive Secondary

Market EFSF Funding Market
PurchasesBasiert auf Eurogruppe, EIB, ECB,Purchases

Vorsorge-
Funds to recapitalize Other uses Kreditlinien
genuine Precautionary
banks ESM
EMF? Facilities
...a in all but name? (Sarkozy)

576
576
3. Progress in financial supervision and resolution
New supervisory framework (since Jan 2011)

EBA, gradual progress towards single rulebook main role still
played by national supervisors
EU Bank Recovery & Resolution Directive (COM proposal)

Harmonised powers for early interventions, new resolution tools,
framework for cross-border cooperation
Deposit Guarantee Schemes Directive (text in trialogue)

Harmonisation of levels (at EUR 100,000)
Enough to secure monetary dominance ?
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?
Strengthened micro and macro prudential regulation of risk

Strengthened EBA?
New Authority with mandate for cross border supervision?
Harmonised deposit guarantee scheme
Recapitalisation of financial institutions
Direct recapitalisation of banks by the ESM
Resolution
Network of resolution funds? Common fund financed by the industry?
579
Exchange Rate Policy can be characterized
along two dimensions
Currency
Union (Euro)
Commitment
Hard Peg Pure Float

(China) (USA)
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
Jan Feb Mar Apr May
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
Jan Feb Mar Apr May
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
Jan Feb Mar Apr May
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
Jan Feb Mar Apr May
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%
Jan Feb Mar Apr May
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
Fixed Exchange Rate: This is simply a policy decision

of the government or central bank and can be
easily reversed (China).
Commitment
Currency Boards: A currency board is a monetary

authority separate from (or in replacement of) a
countrys central bank whose sole responsibility is
maintaining convertibility of the countrys
currency. (Hong Kong)
Dollarization/Currency Union: foreign money

replaces domestic money as official currency
(Panama)
587
Exchange Rate Systems
Pure Float
6% 21% Managed Float

10%
5% Crawling Peg or
Band
Target Zone
14%
20%
Pure Peg
24% Currency Board
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
Currently, the reserve ratio is 65% (6.5M/10M)
591
If we are going to analyze the policy options, we need a structured
framework to proceed.
Long Run Short Run

PPP holds Commodity prices are fixed
Relative prices are (PPP fails)
constant. Therefore, the UIP and Currency markets
real exchange rate equals determine exchange rates
one
The nominal exchange rate
returns to its
fundamentals
592
Using PPP and the two Money Market equilibrium conditions, we get the
fundamentals for a currency
Domestic Money Market Foreign Money Market
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
Now, solve for

M

*
Y 1 i
M 1.30 M *
*

Y 1 i
We now have the US monetary

policy rule
594
This is actually better expressed in percentage terms

%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.
To maintain the peg, the US would have to increase

the US money supply by 3% relative to Europe
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
Suppose that Europe was following an irresponsible monetary policy

(excessive money growth). If the US was pegging to the Euro, we
would be forced into the same irresponsible behavior!
596
You need to choose a currency regime that is compatible in the
long run with your economic fundamentals
Jan Feb Mar Apr May
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)
The reserve ratio drops to 59% (6.5M/11M)
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
With a BOP deficit, Federal Reserve must

use Euro reserves to buy dollars in order to
maintain the peg
The Fed Conducts an open market purchase of Dollars
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)
The reserve ratio drops to 55% (5.5M/10M)

Note: The money supply returns to $10M
600
Suppose that the US Government runs a deficit (either
spending increases or tax cuts) to stimulate the
economy
Increased spending increases the trade deficit
Higher government debt raises the interest rate (this attracts
foreign capital)
i
LM
Can this policy be

maintained under a
i
currency peg system?
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
The balance of payments surplus forces the dollar to

appreciate in the short run.
The Fed Conducts an open market sale of Dollars to maintain the peg
with the Euro
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)
The reserve ratio rises to 68% (7.5M/11M)

603
With low capital mobility, high US interest rates are unable to attract
sufficient financing for the trade deficit. A BOP deficit causes the dollar
to depreciate
i BOP 0 LM
i
BOP CA KFA
IS
y
The balance of payments surplus forces the dollar to

depreciate in the short run.
The Fed Conducts an open market purchase of Dollars to maintain
the peg with the Euro
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)
The reserve ratio falls to 61% (5.5M/9M)

The purchase of dollars contracts the money supply. Can the Fed avoid
this monetary contraction?
605
The Fed Conducts an open market purchase of Treasuries to
Sterilize the currency intervention
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)

606
Suppose that foreign investors view US debt as too risky?
Financial flows reverse, the US runs a BOP deficit requiring a
purchase of dollars
i
LM
i Reversal of capital flows

causes the dollar to begin
to depreciate. The US
IS must correct this by
y buying dollars.
Note: This would contract the money supply raising interest

rates and lowering output.
The Fed Conducts an open market purchase of dollars to
stabilize the exchange rate
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)

608
Suppose that foreign investors view US debt as too risky?
Financial flows reverse, the US runs a BOP deficit.
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
The reserve ratio is at 42% (2.6M/6.1M)

The Fed could fix this problem by devaluing the dollar (i.e.
raising the dollar price of Euro)
The drop in value would hopefully stop the selling
The devaluation would also improve the Feds
reserve position
610
A devaluation from $1.30 to $1.50 helps
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
The reserve ratio is at 49% (3M/6.1M)
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
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
1. Makes domestic businesses less competitive

2. Benefits domestic consumers
FX traded in over-the-counter market
1. Trade is in bank deposits denominated in different currencies 619
Exchange rate
D S
Peso/$ Supply of Dollars by
people who want pesos
Demand for Dollars by

people who have pesos
Foreign exchange (dollars)

620
Currency Depreciation and Appreciation
Currency depreciation is an increase in the number of units

of a particular currency needed to purchase one unit of
foreign exchange
Currency appreciation is a decrease in the number of units

of a particular currency needed to purchase one unit of
foreign exchange
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
Foreign exchange (dollars)

622
Exchange Rate Regimes
Flexible (Floating) exchange rates.
Fixed exchange rates.

Currency Board
Monetary Union
Managed Float (Dirty Float) exchange rates.
623
The Central Bank Can Intervene to Maintain Exchange
Rates
Exchange rate D
$/pound D S
Foreign exchange (pounds)

624
7.4
7.5
7.6
7.7
7.8
7.9
8.1
8.2
8.3
8.4
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
Foreign exchange ($)

626
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
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)
PPP Domestic price level 10%, domestic

currency 10%
1. Application of law of one price to price levels
2. Works in long run, not short run
Problems with PPP

1. All goods not identical in both countries: Toyota vs Chevy
2. Many goods and services are not traded: e.g. haircuts
629
Big Mac
Index
630
PPP: U.S. and U.K
631
Factors Affecting E in Long Run
Basic Principle: If factor increases demand for domestic goods

relative to foreign goods, E
632
Exchange Rates in the Short Run
An exchange rate is the price of domestic assets in terms of
foreign assets
Using the theory of asset demandthe most important
factor affecting the demand for domestic (dollar) assets and
foreign (euro) assets is the expected return on these assets
relative to each other
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:
$ and Euro deposits perfect substitutes

iD = iF (Eet+1 Et)/Et
Example: if iD = 10% and expected appreciation of $,

(Eet+1 Et)/Et, = 5% iF = 15%
634
Deriving RF Curve
Assume iF = 10%, Eet+1 = 1 euro/$

Point
A: Et = 0.95, RF = .10 (1 0.95)/0.95 = .048 = 4.8%
B: Et = 1.00, RF = .10 (1 1.0)/1.0 = .100 =10.0%
C: Et = 1.05, RF = .10 (1 1.05)/1.05 = .148 = 14.8%
RF curve connects these points and is upward sloping because when Et is higher,
expected appreciation of F higher, RF
Deriving RD Curve
Points B, D, E, RD = 10%: so curve is vertical
Equilibrium
RD = RF at E*
If Et > E*, RF > RD, sell $, Et
If Et < E*, RF < RD, buy $, Et
635
Equilibrium in the Foreign Exchange Market
636
Shifts in RF
RF curve shifts right when

1. iF : because RF at
each Et
2. Eet+1 : because expected
appreciation of F at
each Et and RF
Occurs Eet+1 iF:
1) Domestic P ,
2) Trade Barriers
3) Imports ,
4) Exports ,
5) Productivity
637
Shifts in RD
RD shifts right when

1. iD ; because RD
at each Et
Assumes that domestic e
unchanged, so domestic
real rate
638
Foreign Exchange I
Exchange rateprice of one currency in terms of another

Foreign exchange marketthe financial market where
exchange rates are determined
Spot transactionimmediate (two-day) exchange of bank
deposits
Spot exchange rate
Forward transactionthe exchange of bank deposits at
some specified future date
Forward exchange rate
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
RF out > RD out and Et
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?
1. Expectations of Eet+1 fluctuate

2. Exchange rate overshooting
646
The Dollar and Interest Rates
1. Value of $ and real

rates rise and fall
together, as theory
predicts
2. No association
between $ and
nominal rates: $ falls
in late 70s as nominal
rate rises
647
648
649
650
651
652
Chapter 18
The International Financial System
653
Unsterilized Foreign Exchange Intervention
Federal Reserve System Federal Reserve System
Assets Liabilities Assets Liabilities
Foreign -$1B Currency in -$1B Foreign -$1B Deposits with -$1B

Assets circulation Assets the Fed
(International (International (reserves)
Reserves) Reserves)
A central banks purchase of domestic currency and corresponding sale of foreign

assets in the foreign exchange market leads to an equal decline in its
international reserves and the monetary base
A central banks sale of domestic currency to purchase foreign assets in the
foreign exchange market results in an equal rise in its international reserves and
the monetary base
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
Foreign Assets Monetary Base
(International Reserves) -$1B (reserves) 0
Government Bonds +$1B
To counter the effect of the foreign exchange intervention,

conduct an offsetting open market operation
There is no effect on the monetary base and no effect on the
exchange rate
657
Balance of Payments
Current Account Capital Account

International transactions Net receipts from capital
that involve currently transactions
produced goods and services
Sum of these two is the
Trade Balance official reserve transactions
balance
658
Monetary Policy Strategy:
The International Experience
659
Role of a Nominal Anchor
Ties Down Expectations
Helps Avoid Time-Consistency Problem

1. Arises from pursuit of short-term goals which lead to bad long-term
outcomes
2. Time-consistency resides more in political process
3. Nominal anchor limits political pressure for time-consistency
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
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
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
The expected return on dollar assets R D in terms of foreign currency

is the sum of the interest rate on dollar assets
plus the expected appreciation of the dollar
Ete1 Et
R D
in term of euros = i D
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
The expected return on foreign assets R F in terms of dollars

is the interest rate on foreign assets i F plus the expected appreciation
of the foreign currency, equal to minus the expected appreciation of the dollar
e
Et1 Et
R in terms of dollars = i
F F
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
European Monetary System

Exchange rate mechanism
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
Exchange rates adjusted only when experiencing a fundamental

disequilibrium (large persistent deficits in balance of payments)
Loans from IMF to cover loss in international reserves
IMF encourages contractionary monetary policies
Devaluation only if IMF loans are not sufficient
No tools for surplus countries
U.S. could not devalue currency
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
Current account deficits in the U.S. suggest that American businesses

may be losing ability to compete because the dollar is too strong
U.S. deficits mean surpluses in other countries large increases in
their international reserve holdings
world inflation
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
Contributes to keeping inflation
under control
Automatic rule for conduct of
monetary policy
Simplicity and clarity
702
Disadvantages of
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
for Industrialized Countries
Domestic monetary and political institutions are not conducive to
good policy making
Other important benefits such
as integration
704
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
III. Advantages of floating rates

IV. Which regime dominates?
V. Additional factors for developing countries
Emigrants remittances
Financial development
Terms-of-trade shocks; the PEP proposal
Appendices:
1. The RMB case
2. Corners
3. More on synthesis technique for regime estimation 712
I. Classification of exchange rate regimes:
Continuum from flexible to rigid
FLEXIBLE CORNER
1) Free float 2) Managed float
INTERMEDIATE REGIMES
3) Target zone/band 4) Basket peg
5) Crawling peg 6) Adjustable peg
FIXED CORNER
7) Currency board 8) Dollarization

Intermediate regimes
target zone (band)
Krugman-ERM type (with nominal anchor)
Bergsten-Williamson type (FEER adjusted automatically)
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
Many countries that say they float,

in fact intervene heavily in the foreign exchange market. [1]
Many countries that say they fix,
in fact devalue when trouble arises. [2]
Many countries that say they target a basket of currencies,
in fact fiddle with the weights. [3]
[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.
[1] See Bnassy-Qur, et al (Table 5, 2004);

Frankel (Table 1, 2004); and Shambaugh (2004b): 716
Correlations Among Regime Classification
Schemes
IMF GGW LY-S R-R
IMF
1.00
(100.0)
GGW
0.60 1.00
(55.1) (100.0)
LY-S
0.28 0.13 1.00
(41.0) (35.3) (100.0)
0.33 0.34 0.41 1.00
R-R
(55.1) (35.2) (45.3) (100.0)
(Frequency of outright coincidence, in %, given in parenthesis.)
GGW =Ghosh, Gulde & Wolf. LY-S = Levy-Yeyati & Sturzenegger. R-R = Reinhart & Rogoff
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.
Percentage agreement of methodologies to code who pegs

De
Jay S. LY-S R-R
Jure
De
100%
Jure
Jay S. 86% 100%
LY-S 74% 80% 100%
R-R 81% 82% 73% 100%
718
The IMF now has its own de facto classification
-- but still close to official IMF one: correlation (BOR, IMF) = .76
Bnassy-Qur et al (2004)
719
=> Something must be wrong.
Several things are 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.
That problem can be addressed by comparing exchange rate

variability to foreign exchange reserve variability:
Calvo & Reinhart (2002);

Levy-Yeyati & Sturzenegger (2003, 2005).
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 $).
It would be better to estimate endogenously whether the

anchor currency is the $, the , some other currency, or
some basket of currencies.
That problem has been addressed by a 2nd approach:
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
Difficulty #3: The 2nd approach

(inferring the anchor currency or basket)
does not allow for flexibility around that anchor.
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.
=> We need a synthesis that can cover both

dimensions: inferring weights and inferring flexibility.
727
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.
E.g., Chile changed parameters 18 times in 18 years (1980s-90s)

Year-by-year estimation wont work,
because parameter changes come at irregular intervals.
Chow test wont work,
because one does not usually know the candidate dates.
Solution: Apply Bai-Perron (1998, 2003) technique
for endogenous estimation of structural break point dates.
728
Statistical estimation of de facto exchange rate regimes
Estimation of implicit weights
in basket peg: Frankel (1993),
Estimation of degree of
Frankel & Wei (1993, 94, 95); flexibility in managed float:
Calvo & Reinhart (2002); Levi-
Ohno (1999), F, Schmukler & Servn
Yeyati & Sturzenegger (2003)
(2000), Bnassy-Qur (1999, 2006)
Application to RMB:
Eichengreen (06), Ogawa (06), F & Wei (07)
Synthesis: Estimation of De Facto Exchange Rate

Regimes: Synthesis of the Techniques for Inferring
Flexibility and Basket Weights Frankel & Wei (IMF SP 2008)
Econometric estimation of structural

Application to RMB: Frankel (2009)
break points: Bai & Perron (1998, 2003)
Allow for parameter variation: Estimation of De Facto Flexibility Parameter

and Basket Weights in Evolving Exchange Rate Regimes F & Xie (AER, 2010)
729
The technique that estimates basket weights
Assuming the value of the home currency is determined by a currency basket,
how does
one uncover the currency composition & weights?
Regress changes in log H, the value of the home currency, against changes in log
values of candidate currencies.
Algebraically, if the value of the home currency H is pegged to the values of

currencies X1, X2, & Xn, with weights equal to w1, w2, & wn, then
logH(t) =c + w(j) [ logX(j)] (1)
730
log Ht
= c + w(j) [ logX(j)t ]
= c + w(1) log $ t + w(2) log t
+ w(3) log t + log t
If the exchange rate is governed by a strict basket peg,

we should recover the true weights, w(j), precisely;
and the equation should have a perfect fit.
731
Distillation of technique to infer flexibility
When a shock raises international demand for the currency,
do the authorities allow it to show up as an appreciation,
or as a rise in reserves?
Frame the issue in terms of Exchange Market Pressure
(EMP), defined as: % increase in the value of the currency
plus increase in reserves (as share of monetary base).
EMP variable appears on the RHS of the equation.
The % rise in the value of the currency appears on the left.
A coefficient of 0 on EMP signifies a fixed E
(no changes in the value of the currency),
a coefficient of 1 signifies a freely floating rate
(no changes in reserves) and
a coefficient somewhere in between indicates
a correspondingly flexible/stable intermediate regime.
732
Synthesis equation
logH(t) = c + w(j) [logX(j, t)]

+ { EMP(t)} + u(t) (2)
where
EMP(t) [logH(t)] + [Res(t) / MB(t)].
We impose w(j) = 1, implemented by treating as the last currency.
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
For further details, see NBER WP, Dec. 2009.
734
Illustration using 5 currencies
These are 5 emerging market currencies of interest

all of which now make available their data on
reserves on a weekly basis
(which is necessary to get good estimates, if structural changes
happen as often as yearly)
Mexico (monetary base is also available weekly)
Chile, Russia, Thailand, India
(although reserves available weekly, denominator must be
interpolated from monthly monetary base data)
735
Overview of findings
For all five, the estimates suggest managed floats

during most of the period 1999-2009.
This was a new development for emerging markets.
Most of the countries had had some variety of a
peg before the currency crises of the 1990s.
But the Bai-Perron test shows statistically significant
structural breaks for every currency,
even when the threshold is set high, at the 1% level
of statistical significance.
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)
VARIABLES 1/21/1999- 9/9/2001- 3/25/2003- 8/5/2006- 2/4/2008- 12/22/2008-

9/2/2001 3/18/2003 7/29/2006 1/28/2008 12/15/2008 7/29/2009
US dollar 0.92*** 0.88*** 0.62*** 1.11*** 0.96*** 0.20

(0.09) (0.12) (0.07) (0.10) (0.19) (0.22)
euro 0.14 -0.09 0.30*** 0.20* 0.51*** 0.51***

(0.08) (0.14) (0.09) (0.11) (0.16) (0.18)
Jpn yen -0.05 0.22*** 0.08 -0.34*** -0.33** 0.18

(0.06) (0.07) (0.06) (0.06) (0.12) (0.13)
EMP 0.14*** 0.32*** 0.17*** 0.02 0.07 0.28***

(0.03) (0.03) (0.03) (0.02) (0.07) (0.04)
Constant 0.00 -0.00*** -0.00* -0.00 -0.00 0.00

(0.00) (0.00) (0.00) (0.00) (0.00) (0.00)
Observations 131 78 168 76 46 29

R-squared 0.62 0.86 0.69 0.67 0.54 0.78 738
Br. Pound -0.01 -0.01 -0.01 0.02 -0.14 0.11
Tables 1B-1E
Chile (with 3 estimated structural breaks) appears a managed
floater throughout.
The anchor is exclusively the $ in some periods,
but puts significant weight on the in other periods.
Russia (3 structural breaks) is similar,

except that the $ weight is always significantly less than 1.
For Thailand (3 structural breaks), the $ share in the anchor

basket is slightly > .6, but usually significantly < 1.
The & show weights of about .2 each Jan.1999-Sept. 2006.
India (5 structural breaks) apparently fixed its exchange rate

during two of the sub-periods, but pursued a managed float in
the other four sub-periods.
$ was always the most important of the anchor currencies, but the was also
significant in four out of six sub-periods, and the in two.
739
Future research
Results for other currencies will be published in other papers

Often requiring weekly interpolation between monthly reserve figures.
Including our China updates
And true basket/band/crawl currencies
Econometric extension: use Threshold Autoregression for target zones.
740
Bottom line
on classifying exchange rate regimes
It is genuinely difficult to classify

most countries de facto regimes:
intermediate regimes that change over time.
Need techniques
that allow for intermediate regimes
(managed floating and basket anchors)
and that allow the parameters to change over time.
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.
Empirical: Exchange rate volatility => trade ?

Time-series evidence showed little effect. But more in:
- Cross-section evidence,
especially small & less developed countries.
- Borders, e.g., Canada-US:
McCallum-Helliwell (1995-98); Engel-Rogers (1996).
- Currency unions: Rose (2000). 742
The case of the euros effect on trade
Frankel, The Estimated Effects of the Euro on Trade: Why are They Below
Historical Evidence on Effects of Monetary Unions Among Smaller Countries?
in Europe and the Euro, edited by A.Alesina & F.Giavazzi, 2010.
1. Gravity estimates of effect of on intra-EMU trade

in the first decade show the coefficient steady 15% .
2. << estimates of other Monetary Unions effects (x2 or x3)
3. No evidence that the gap is explained by a MU effect that
1. diminishes with country size, or
2. is subject to long lags.
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.
But in Jan. 1999, 14 CFA countries suddenly found themselves with

the same currency link to Germany, Austria, Finland, etc.
No economic/political motivation. A natural experiment.
If CFA trade with these other countries has risen,
that suggests a effect that we can declare causal.
745
745
Results of CFA experiment
The dummy variable

representing when one partner is
a CFA country and the other a country
has a highly significant coefficient of .57.
Taking the exponent, the point estimate
is that the euro boosts bilateral trade between the relevant African and
countries by 76%.
746
746
Bottom line on discrepancy in effect
The large effect of monetary unions on developing countries is real.

Tentative conclusion:
Although monetary unions dont have larger effects on small countries per se,
They do have larger effects on poor countries per se.
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
4) Avoid competitive depreciation
5) Avoid speculative bubbles that afflict floating.

(If variability were all fundamental real exchange rate risk, and no bubbles,
then fixing the nominal rate would mean it would just pop up in prices instead.)
Most important finding of last decade
Empirical finding of Rose (2000) that the boost to bilateral
trade from currency unions is significant, FTAs, & larger
(3-fold) than had been thought.
Many others have advanced critiques of Rose research.
Re: Endogeneity, small countries, missing variables & sheer magnitude.
Estimated magnitudes are often smaller, but the basic finding

has withstood perturbations and replications remarkably well. ii/
Some developing countries seeking regional integration
talk of following Europes lead, tho plans merit skepticism.
Parsley-Wei: currency effect explains border effects.
Klein-Shambaugh: de facto pegs have major effect too.
[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.
Endogeneity of OCA criteria:

Trade responds positively to currency regime
A pairs cyclical correlation rises too
(rather than falling, as under Eichengreen-Krugman hypothesis)
-- Frankel & Rose, EJ, 1996
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.
To over-simplify findings of 3 important studies:

Ghosh, Gulde & Wolf: hard pegs work best
Sturzenegger & Levy-Yeyati: floats perform best
Reinhart-Rogoff: limited flexibility is best
Why the different answers?
Conditioning factors.
The de facto schemes do not correspond to each other.
Which category
experienced the
most rapid
growth?
Ghosh, Gulde
& Wolf:
currency boards
Levy-
Yeyati &
Sturzenegg
er:
floating
Reinhart &
Rogoff:
limited
flexibility
753
Which dominate: advantages of
fixing or advantages of floating?
Answer depends on circumstances, of course:

No one exchange rate regime is right
for all countries or all times.
Traditional criteria for choosing - Optimum Currency Area.

Focus is on trade and stabilization of business cycle.
1990s criteria for choosing
Focus is on financial markets and stabilization of speculation.
754
Optimum Currency Area Theory (OCA)
Broad definition: An optimum currency area is a region

that should have its own currency and own monetary policy.
This definition can be given more content:.

An OCA can be defined as:
a region that is neither so small and open that it would be
better off pegging its currency to a neighbor, nor so large
that it would be better off splitting into sub-regions with
different currencies
755
Optimum Currency Area criteria for
fixing exchange rate:
Small size and openness

because then advantages of fixing are large.
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.
Fiscal transfers in a federal system
because then consumption is cushioned in a downturn.
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
Regarding other initial conditions:

an already-high level of private dollarization
high pass-through to import prices
access to an adequate level of reserves
the rule of law.
758
V. Three additional considerations, particularly
relevant
to developing countries
(i) Emigrants remittances

(ii) Level of financial development
(iii) External terms of trade shocks
and the proposal to Peg the Export Price
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.
Evidence on the Dutch Disease.

On the one hand, Rajan & Subramanian (2005): although the Dutch Disease analogy
does extend to foreign aid (leading to real appreciation & slow growth), it does not
extend to remittances.
On the other hand, Amuendo-Dorantes & Pozo (2004): an increase in remittances to
LACA countries leads to real appreciation, a major symptom of Dutch Disease.
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***
(0.040) (0.041) (0.088) (0.152)

Cyclical Difference (Ln (Real GDP/ Trend GDP)) 16.199*** 16.099*** 14.723*** 13.983***
Sender relative to recipient (2.905) (2.765) (3.390) (3.927)
GDP per capita Sender 0.039*** 0.028* 0.022
(0.015) (0.016) (0.019)
Currency Union 1.345*** 0.087 -0.590
(0.222) (0.389) (0.632)

Estimation Method OLS OLS 2SLS 2SLS
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)
Fixed rates are better for countries at

low levels of financial development:
because markets are thin =>
benefits of accommodating real shocks are outweighed by
costs of financial shocks.
When financial markets develop, exchange flexibility becomes
more attractive.
Estimated threshold: Private Credit/GDP > 40%.
Level of financial development, cont.
Husain, Mody & Rogoff, JME 52 , Jan. 2005 35-64
For poor countries with low capital mobility, pegs work

in the sense of being more durable
& delivering low inflation
For richer & more financially developed countries,

flexible rates work better
in the sense of being more durable
& delivering higher growth without inflation
(iii) External Shocks
An old wisdom regarding the source of shocks:

Fixed rates work best if shocks are mostly internal demand shocks (especially
monetary);
floating rates work best if shocks tend to be real shocks (especially external terms
of trade).
One case of supply shocks: natural disasters

R.Ramcharan, 2007, finds support.
Does the Exchange Rate Regime Matter for Real Shocks? Evidence from Windstorms and Earthquakes, JIE.
Most common case of real shocks: trade
767
Terms-of-trade variability returns
Prices of crude oil and other agricultural & mineral

commodities hit record highs in 2008.
=> Favorable terms of trade shocks for some
(oil producers, Chile, Africa, 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.
Edwards & L.Yeyati (2003): Among peggers, terms-of-trade
shocks are amplified and long-run growth is reduced,
as compared to flexible-rate countries.
Fashions in international currency policy
1980-82: Monetarism (target the money supply)
1984-1997: Fixed exchange rates
(incl. currency boards)
1993-2001: The corners hypothesis
1998-2008: Inflation targeting (+ currency float)
became the new conventional wisdom
Among academic economists
Among central bankers
At the IMF
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.
Economists, central bankers, IMF

Flexible inflation targeting
Have a LR target for inflation, and be transparent. ?
Who could disagree?
But define IT as setting yearly CPI targets, to the exclusion of

asset prices
exchange rates
export commodity prices.
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
Monetarist rule M1 Velocity shocks US 1982

CPI Import price Oil shocks of
Inflation targeting
shocks 1973-80, 2000-08
Nominal income Nominal Measurement Less developed
targeting GDP problems countries
Price Vagaries of world 1849 boom;
Gold standard
of gold gold market 1873-96 bust
Price of agric. Shocks in
Commodity Oil shocks of
& mineral imported
standard 1973-80, 2000-08
basket commodity
Fixed $ Appreciation of $ 1995-2001
exchange rate (or ) (or )
774
PE
How would it work operationally, say,
P
for a Gulf oil-exporter?
Each day, after noon spot price of oil in London S($/barrel),

the central bank announces the days exchange rate,
according to the formula:
E (dirham/$) = fixed target price P(dirham/barrel) / S($/barrel). It
intervenes in $ to hold this exchange rate for the day.
The result is that P (dirham/barrel)
is indeed fixed from day to day.
Does floating give the same answer?
True, commodity currencies tend to appreciate

when commodity markets are strong, & vice versa
Australian, Canadian & NZ $ (e.g., Chen & Rogoff, 2003)
South African rand (e.g., Frankel, 2007)
Chilean peso and others
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
Better response to adverse terms of trade shocks:
If the $ price of imported commodity goes up, CPI

target says to tighten monetary policy enough to
appreciate currency.
Wrong response. (E.g., oil-importers in 2007-08.)
If the $ price of the export commodity goes up, PEP

says to tighten monetary policy enough to
appreciate currency.
Right response. (E.g., Gulf currencies in 2007-08.)
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.
The volatility is undesirable, in particular, for those

short-term fluctuations that are likely to be reversed.
Better to dampen real exchange rate fluctuations a bit,
until terms of trade shift appears permanent.
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.
Target a basket of major currencies ($, , ) and minerals.
A still more moderate, still less exotic-sounding, version of PEPI

proposal: target a monthly index of producer prices.
Key point: exclude import prices from the index,

& include export prices.
Flaw of CPI target: it does it the other way around.
780
781
Readings:
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

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Basic Points About Money

Origin of money with Goldsmiths; Bank of England -1994

Currency, Demand and time deposits, Financial assets

Why do people want money?

Targets: inflation only; or money supply only; or exchange

Instruments: Open market operation on treasury bills -

Two Conditions to have real effect of Monetary policy

Households: saving, housing, wealth,

Time lags: anticipated and unanticipated

Interest rate Channel Credit Channel

Exchange Rate Channel

Expansionary Monetary Policy

Missing Link for Keynes

Interest rate is determined by the supply and demand

Three kinds of demand

Demand for money is not stable because of chaning

Interest Interest rate

Demand for and Supply of Money Demand for bonds

Money supply is controlled by the policy maker

If we considering a leakage in the currency holding:

Cambridge equation of money demand:

Keynesian money demand

Monetary authority can control nominal quantities such

Price mechanism in the market system works better when

Transmission mechanism of monetary policy: impact of of interest decision in the economy

restrict the development of financial

refinance and discount facilities;

: measures the riskiness of the project.

applicants, less risky borrowers drop out of the

which the probability of default is higher (because

profit, which may dominate the positive effect of an

those emphasized by Stiglitz and Weiss may

requirements and the contractual loan rate to

projects differ in their distributions of return before

ante identical but lenders must incur ex post

Open market operations

What happens to the quantity of reserves demanded, holding

Two components: non-borrowed and

An open market purchase causes the federal

If the intersection of supply and demand occurs on

Dynamic open market operations

The Fed has complete control over

Used to perform role of lender of

Depository Institutions Deregulation and Monetary

No longer binding for most banks

Sets up a standing lending facility (lombard

The supply of reserves is also infinitely elastic

Open market operations

Traditional policy tools are:

Fed determines reserves (R), discount % (id)

S vertical because supply of reserves

Home mortgage & corporate bond

Purchases Lower Federal Funds % Sales Raise Federal Funds %

Changes in the Discount Rate

Changes in the Required Reserve Ratio

Implementing Open Market Operations

Defensive open market operations offset temporary fluctuations in reserves ( due to

Fannie Mae & Freddie Mac (government agencies - major

Categories of Discount Loans

Discount Lending during the Financial Crisis of 20072009

If demand for reserves or shifts right If demand for reserves or

Historically, Taylor rule explains

Arguments against an inflation target:

The German Central Bank (Bundesbank)