Latin America's Reaction to QE2: The Impossible Trinity

1. More Slides fromEd Dolan’s Econ Bloghttp://dolanecon.blogspot.com/The Impossible Trinity, or, Why Latin AmericaHates QE2Posted January 19, 2011 Terms of Use: These slides are made available under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishers.

2. Latin America Up in Arms over QE2 • Latin America is up in arms over the Fed’s program of quantitative easing, known as QE2 • Brazil and Chile, among the most affected countries, have undertaken actions to protect their economies • Why the harsh reaction, when most people in the United States view QE2 as a purely domestic policy designed to reboot a faltering economic recovery? “This is a currency war that is turning into a trade war.” —Guido Mantega Finance Minister of Brazil Photo source: AgenciaBrasil, http://commons.wikimedia.org/wiki/File:Guido_mantega.jpg Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

3. Making Waves • Fact No. 1: There is no such thing as purely domestic monetary policy in today’s world • Central bank actions of even the smallest countries create ripples in the global financial system • The Fed’s actions can create bigger waves Photo source: MaleneThyssen, http://commons.wikimedia.org/wiki/User:Malene Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

4. How QE2 Affects the Global Economy • The Fed’s purchases of longer-term Treasury securities under QE2 tend to reduce yields on those securities • Paying for the purchases increases bank reserves, putting additional downward pressure on US interest rates • When US interest rates fall, some investors look for better opportunities abroad • Countries like Brazil, Chile, and others experience increased financial inflows The Federal Reserve Building in Washington, D.C. Photo source: AgnosticPreachersKid, http://commons.wikimedia.org/wiki/File:Marriner_S._Eccles_Federal_Reserve_Board_Building.jpg Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

5. The Impossible Trinity According to the “impossible trinity,” a country can choose only two of the following three: • An independent monetary policy • An open capital account • A fixed exchange rate Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

6. Effects of Financial Inflows: Variant 1 • If a country chooses an independent monetary policy and an open capital account, it must have a floating exchange rate • An increase in financial inflows will cause its exchange rate to appreciate • Consumers and other buyers of imported goods will benefit, but exporters and manufacturers that compete with imports will suffer • If the political influence of exporters and import-competitors is disproportionately great, as is often the case, then the political reaction to currency appreciation will be mostly negative Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

7. Effects of Financial Inflows: Variant 2 • If a country chooses a fixed exchange rate and an open capital account, it loses independent control of monetary policy • When financial inflows increase, the central bank must buy foreign currency in order to prevent exchange-rate appreciation • It pays for the foreign currency with newly created domestic money • The increased money supply causes inflation, which, in turn, undercuts the competitiveness of exports • This combination of a fixed nominal exchange rate plus inflation can also be described as real appreciation of the country’s currency Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

8. Effects of Financial Inflows: Variant 3 • A country can maintain fixed exchange rate and use its monetary policy independently to control inflation if it closes the capital account and blocks unwanted financial inflows • Orthodox economics has tended to frown on this option because cutting off financial inflows can deprive the economy of a vital source of capital • In that case, stability of the exchange rate and the price level comes at the expense of slow economic growth Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

9. Compromise policy: Partial capital controls • Some countries, including Brazil and Chile, have tried a compromise policy that partly restricts financial inflows without completely closing the capital account • The idea is to filter out unwanted, short-term, speculative “hot money” while allowing inflows of growth-promoting, long-run direct foreign investment • These controls may help in the short run, but they may lose their effectiveness over time Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

10. Compromise policy: Sterilization • Another possible compromise, currently being used by Chile, is to “sterilize” foreign exchange market intervention • A central bank is said to sterilize when it buys foreign currency to resist appreciation, and then neutralizes the monetary effects by selling bonds or other non-monetary financial instruments • However, sterilization can be very expensive and may not work well for more than short periods Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

11. Why South America Hates QE2 • The impossible trinity makes it easier to see why South American finance ministers and central bankers do not like QE2 • QE2 causes increased financial inflows, which cause unwanted inflation and exchange rate appreciation • Countermeasures can be taken, but because of the impossible trinity, all countermeasures involve costs and compromises Photo source: NASA, http://commons.wikimedia.org/wiki/File:South_America_satellite_plane.jpg Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

12. But QE2 is Only Part of the Problem • However, QE2 is only one among many sources of Latin America’s problems • As this chart shows, the trend toward real exchange rate appreciation was underway long before QE2 • Other causes of currency appreciation in Latin America: • Dynamic, well-managed economies that offer many investment opportunities • Increases in world commodity prices during recovery from the global financial crisis Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

13. The Bottom Line: Ripples, but not a Tsunami The bottom line: • QE2 may make life a little harder for Latin American policy makers, but they have other problems as well • QE2 is making ripples in the world financial system, but hardly a tsunami • QE2 is not the start of a global currency war; It is a domestic program with moderate but unavoidable external effects • In the long run, if QE2 works to speed recovery, US trading partners everywhere will benefit Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com