Understanding Key Monetary Policy Issues

1. Key Issues in Monetary and External Sector Policies ThorvaldurGylfason International Monetary Fund/Asian Development Bank Course on Financial Programming and Policies Seoul, Korea, 17-28 May 2010

2. Outline • Transmission of monetary policy • Taxonomy of monetary strategies • Real vs. nominal exchange rates • The scourge of overvaluation • Capital flows • Exchange rate regimes • To float or not to float • Impossible trinity

3. Background • Countries need to choose • A monetary policy strategy • Money growth targets • Inflation targets • An exchange rate arrangement • Fixed exchange rate • Floating exchange rate • The two choices must be compatible • Cannot fix both money growth and exchange rate

4. What is monetary policy? 1 • Broad definition • Everything the monetary authority does • Narrower definition • Efforts by the monetary authority to influence macroeconomic variables

5. The Black Box: How monetary policy is transmitted TRANSMISSION PROCESS: INSTITUTIONAL ENVIRONMENT IN WHICH MONETARY POLICY IS FORMULATED AND IMPLEMENTED MONETARY POLICY INSTRUMENTS OUTCOMES OR GOALS INDIRECT POLICY INSTRUMENTS OPEN MARKET OPERATIONS ASSET PORTFOLIO REQUIREMENTS CASH RESERVE REQUIREMENTS LIQUIDITY RESERVE REQUIREMENTS OFFICIAL CENTRAL BANK LENDING RATES DIRECT POLICY INSTRUMENTS BANK LENDING RATES BANK DEPOSIT RATES HOW MUCH TO LEND TO WHICH SECTOR/FIRM OTHER BANK CAPITAL REQUIREMENTS PRUDENTIAL REGULATION EMPLOYMENT INFLATION GROWTH OPEN CAPITAL MARKETS EXCHANGE RATE STABILITY INTEREST RATE STABILITY EFFICIENT FINANCIAL INTERMEDIATION

6. Direct instruments • Who gets credit and at what price? • Directed credit • Interest rate ceilings • Direct controls on capital inflows and outflows • Bank-by-bank credit ceilings

7. Experience with direct instruments • As a rule, direct instruments do not deliver the intended results • Political interference in credit allocation • Credit misallocation via interest rate ceilings • Hence, large volumes of nonperforming assets combined with slow growth • Eventually, government has to abandon direct instruments as they become too expensive both financially and economically

8. Indirect instruments • Central Bank injects and withdraws liquidity from the financial system • Typically, Central Bank targets a ‘base’ interest rate • Financial system then decides what activities will be financed and at what price • Market-based decisions • Results of injection/withdrawal of liquidity • Interest rates adjust upward or downward • Exchange rates may change • Credit flows from banks to customers change • Incomes and prices change

9. Indirect instruments • Instruments of monetary control are variables that the central bank actually regulates to reach targets • Open market operations • Discount facility • Reserve requirements

10. A transmission mechanism of monetary policy Market rates Productivity Output Asset prices Aggregate Demand Monetary Policy Expectations/ Confidence Inflation Exchange rate pass-through Import prices Exchange rate

11. Monetary policy strategies: Taxonomy 2 • Exchange rate targeting • Targeting monetary aggregates • Inflation targeting • Other “eclectic” frameworks

12. Exchange rate targeting Set M so as to attain e = e* • Involves adjusting monetary policy instruments to keep exchange rate fixed within a narrow range of some announced target level (i.e., par value) • Pre-World-War-I gold standard • Bretton Woods regime (1945-71) • European ERM (1979-92) • Many low-income countries today

13. Targeting monetary aggregates Set M = M* and let e float • Involves adjusting monetary policy instruments to target the growth rate of some selected measure of the money supply • Many industrial countries from late-1970s to mid-1980s • About 22 countries today • But none of the industrial countries

14. Inflation targeting Set p = p* and let M and e float • Involves adjusting monetary policy instruments to keep the central bank’s forecast of inflation consistent with an announced target • About 45 industrial and emerging-market countries today • First introduced by New Zealand in December 1989

15. Eclectic monetary policy Be flexible • Generally involves adjusting monetary policy instruments to pursue stable economic growth and low inflation, but with no formally announced targets • United States, Japan, Switzerland, India, Singapore, and at least 20 other countries today

16. 3 Real vs. nominal exchange rates Increase in Q means real appreciation e refers to foreign currency content of domestic currency Q = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad

17. Real vs. nominal exchange rates Devaluation or depreciation of e makes Q also depreciate unless P rises so as to leave Q unchanged Q = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad

18. Three thought experiments 1. Suppose e falls Then more won per dollar, so X rises, Z falls 2. Suppose P falls Then X rises, Z falls 3. Suppose P* rises Then X rises, Z falls Summarize all three by supposingQ falls Then X rises, Z falls

19. 4 The scourge of overvaluation • Governments may try to keep the national currency overvalued • To keep foreign exchange cheap • To have power to ration scarce foreign exchange • To make GNP look larger than it is • Other examples of price ceilings • Negative real interest rates • Rent controls

20. Inflation and overvaluation • Inflation can result in an overvaluation of the national currency • Remember: Q = eP/P* • Suppose e adjusts to P with a lag • Then Q is directly proportional to inflation • Numerical example

21. Inflationand overvaluation Real exchange rate Suppose inflation is 10 percent per year 110 Average 105 100 Time

22. Hence, increased inflation increases the real exchange rate as long as the nominal exchange rate adjusts with a lag Inflation and overvaluation Real exchange rate Suppose inflation rises to 20 percent per year 120 110 Average 100 Time

23. How to correct overvaluation • Under a floating exchange rate regime • Adjustment is automatic: e moves • Under a fixed exchange rate regime • Devaluation will lower e and thereby also Q – provided inflation is kept under control • Does devaluation improve the current account? • The Marshall-Lerner condition

24. The Marshall-Lerner condition: Theory Suppose prices are fixed, so that e = Q; e = $ per rupee B = eX – Z = eX(e) – Z(e) Not obvious that a lower e helps B Let’s do the arithmetic Bottom line is: Devaluation strengthens the current account as long as Valuation effect arises from the ability to affect foreign prices a = elasticity of exports b = elasticity of imports

25. TheMarshall-Lerner condition - + Import elasticity Export elasticity -a b 1 1

26. TheMarshall-Lerner condition Assume X = Z/e initially X if Appreciation weakens current account

27. The Marshall-Lerner condition: Evidence Econometric studies indicate that the Marshall-Lerner condition is almost invariably satisfied Industrial countries: a = 1, b = 1 Developing countries: a = 1, b = 1.5 Hence, Devaluation strengthens the current account

28. Empirical evidence from developing countries Elasticity of Elasticity of exports imports Argentina 0.6 0.9 Brazil 0.4 1.7 India 0.5 2.2 Kenya 1.0 0.8 Korea 2.5 0.8 Morocco 0.7 1.0 Pakistan 1.8 0.8 Philippines 0.9 2.7 Turkey 1.4 2.7 Average 1.1 1.5

29. The small country case • Small countries are price takers abroad • Devaluation has no effect on the foreign currency price of exports and imports • So, the valuation effect does not arise • Devaluation will, at worst, if exports and imports are insensitive to exchange rates (a = b = 0), leave the current account unchanged • Hence, if a > 0 or b > 0, devaluation strengthens the current account

30. The importance of appropriate side measures Remember: It is crucial to accompany devaluation by fiscal and monetary restraint in order to prevent prices from rising and thus eating up the benefits of devaluation To work, nominal devaluation must result in real devaluation

31. Capital flows 5 A stylized view of capital mobility 1860-2000 Return toward financial integration First era of international financial integration Capital mobility Capital controls Source: Obstfeld & Taylor (2002), “Globalization and Capital Markets,” NBER WP 8846.

32. Conceptual framework Saving Real interest rate Investment Loanable funds Emerging countries save a little

33. Conceptual framework Real interest rate Saving Investment Loanable funds Industrial countries save a lot

34. Conceptual framework Financial globalization encourages investment in emerging countries and saving in industrial countries Saving Lending Real interest rate Real interest rate Saving Borrowing Investment Investment Loanable funds Loanable funds Emerging countries Industrial countries

35. emerging markets: Net Private Capital Flows, 1980-2009 Source: IMF WEO

36. Push vs. pull factors External factors “pushed” capital from industrial countries to LDCs • Cyclical conditions in industrial countries • Recessions in the early 1990s • Decline in world interest rates • Structural changes in industrial countries • Financial structure developments • Demographic changes

37. Push vs. pull factors Internal factors “pulled” capital into LDCs from industrial countries • Macroeconomic fundamentals • Reduction in barriers to capital flows • Private risk-return characteristics • Creditworthiness • Productivity

38. Potential benefits of capital flows Improved allocation of global savings (allows capital to seek highest returns) Greater efficiency of investment More rapid economic growth Reduced macroeconomic volatility through risk diversification (which dampens business cycles) • Income smoothing • Consumption smoothing

39. Potential risks of capital flows Open capital accounts may make receiving countries vulnerable to foreign shocks • Magnify domestic shocks and lead to contagion • Limit effectiveness of domestic macro policy instruments Countries with open capital accounts are vulnerable to • Shifts in market sentiment • Reversals of capital inflows May lead to macroeconomic crisis • Sudden reserve loss, exchange rate pressure • Excessive BOP and macro adjustment • Financial crisis

40. Potential risks of capital flows Overheating of the economy Excessive expansion of aggregate demand with inflationary pressures, real exchange rate appreciation, widening current account deficit Increase in consumption and investment relative to GDP • Quality of investment suffers • Construction booms Monetary consequences of capital inflows and accumulation of foreign exchange reserves depend crucially on exchange regime

41. Real stock prices during inflow periods, selected countries Chile 1978-81 Mexico Venezuela Chile 1989-94 Sweden Finland Year with respect to start of Inflow period Note: The Index for Finland, Mexico, and Sweden is shown on the left; the index for Chile during the 1980s and 1990s and for Venezuela is shown on the right. Source: World Bank (1997)

42. Stock prices in Thailand 1987-2000

43. Early warning signs Large deficits • Current account deficits • Government budget deficits Poor bank regulation • Government guarantees (implicit or explicit), moral hazard Stock and composition of foreign debt • Ratio of short-term liabilities to foreign reserves Mismatches • Maturity mismatches (borrowing short, lending long) • Currency mismatches (borrowing in foreign currency, lending in domestic currency)

44. Asia: Ratio of short-term liabilities to foreign reserves in 1997

45. Large reversals

46. Country experiences with capital account liberalization • External or financial crisis followed capital account liberalization • E.g., Mexico, Sweden, Turkey, Korea, Paraguay • Response • Rekindled support for capital controls • Focus on sequencing of reforms • Sequencing makes a difference • Strengthen financial sector and prudential framework before removing capital account restrictions • Remove restrictions on FDI inflows early • Liberalize outflows after macroeconomic imbalances have been addressed

47. Some types of capital flows are riskier than others Portfolio equity High degree of risk sharing Foreign direct investment Short term debt Long term debt (bonds) No risk sharing Transitory Permanent

48. Sequencing Capital Account Liberalization Pre-conditions for liberalization • Sound macroeconomic policies • Strong domestic financial system • Strong and autonomous central bank • Timely, accurate, and comprehensive data disclosure

49. 6 Exchange rate regimes • The real exchange rate always floats • Through nominal exchange rate adjustment or price change • Even so, it makes a difference how countries set their nominal exchange rates because floating takes time • There is a wide spectrum of options, from absolutely fixed to completely flexible exchange rates

50. Exchange rate regimes • There is a range of options • Monetary union or dollarization • Means giving up your national currency or sharing it with others (e.g., EMU, CFA, EAC) • Currency board • Legal commitment to exchange domestic for foreign currency at a fixed rate • Fixed exchange rate (peg) • Crawling peg • Managed floating • Pure floating