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Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting International Capital Flows and Destabilizing Fiscal and Monetary Policy Jose Ricardo da Costa e Silva Central Bank of Brazil Federal Reserve Bank – Atlanta, October 2004 Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Disclaim “The views expressed in this work are those of the author and do not reflect those of the Central Bank of Brazil or of its members” Federal Reserve Bank – Atlanta, October 2004 Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Introduction • Motivation: – Developing countries experience larger macroeconomic volatility than developed nations. – Literature suggests that this volatility results in strong welfare losses. – Literature suggests that unstable capital flows and procyclical fiscal policy is one of the reasons for macroeconomic volatility in developing countries, in especial Latin American Countries. Federal Reserve Bank – Atlanta, October 2004 Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Introduction • Objective: – Examine whether Latin American countries practice destabilizing pro-cyclical fiscal and monetary policy, avoiding problem with endogenous regressors. – Analyze the influence of international capital flows on the destabilizing policy. Federal Reserve Bank – Atlanta, October 2004 Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Literature Review • Literature on Pro-cyclical Capital Flows – Finance and business cycle in domestic economy: Gertler (1988), Bernanke and Gertler (1989). – Diaz-Alejandro (1983, 1984), Griffith-Jones and Sunkel (1986), Calvo and Reinhart (1999), Caballero (2000, 2002), Ocampo (2002, 2002), Eichengreen (2003). – Gourinchas (1999), Aghion, Bacchetta and Banerjee (1999). – Fernandez-Arias and Panizza (2001), Calderon and Schmidt-Hebbel (2003). – Ffrench-Davis (2003). Federal Reserve Bank – Atlanta, October 2004 Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting LATIN AMERICA 10 4 2 6 4 0 -1 2 -2 0 -3 -2 -4 GDP growth 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 1977 1976 1975 1974 1973 1972 -5 1971 -4 1970 GDP growth 1 Net transfer of resources as a percentage of GDP 3 8 Net transfer of resources Federal Reserve Bank – Atlanta, October 2004 Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Literature Review • Literature on Pro-cyclical Fiscal Policy – Aizenman, Gavin and Hausmann (1996), Talvi and Vegh (2000) and Riascos and Vegh (2003). – Gavin, Hausmann, Perotti and Talvi (1996), Gavin and Perotti (1997), IMF (2002), Calderon and SchmidtHebbel (2003), Kaminsky, Reinhart and Vegh (2004). – Carvalho (2000), Godfajn (2001), Ocampo (2002, 2003). Federal Reserve Bank – Atlanta, October 2004 Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Brazil =0.46 30 20 10 0 -10 -20 1970 1975 1980 1985 GDPG 1990 1995 2000 CONSGOVG Federal Reserve Bank – Atlanta, October 2004 Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting United Kingdon =-0.11 8 6 4 2 0 -2 -4 1970 1975 1980 1985 GDPG 1990 1995 2000 CO NSGOV Federal Reserve Bank – Atlanta, October 2004 Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Literature Review • Literature on Pro-cyclical Monetary Policy – Calvo and Reinhart (2000), Caballero (2002a). – Calderon and Schmidt-Hebbel (2003). – Carvalho (2000), Gomez (2001). Federal Reserve Bank – Atlanta, October 2004 Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Rationale • Rationale for Pro-cyclical Monetary Policy – Fixed Exchange Rate – Floating Exchange Rate • Floating with inflation-targeting • Fear of Floating. Federal Reserve Bank – Atlanta, October 2004 Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Rationale • Rationale for Pro-cyclical Fiscal Policy – Unfulfilled demand for social and structural investments – Increase in international liquidity: • Increase in revenue • Increase in borrowing – Less interest payment, more revenue to be used in goods and services – In bad times tight fiscal policy is sign of credibility. Federal Reserve Bank – Atlanta, October 2004 Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Econometric Models • Pro-cyclical Monetary and Fiscal Policy GMM: – Policyt = α0 + α1ΔGDPt + α2Policyt-1 + α3Xt +εt, » with ΔGDPt-1 as instrument VAR: Policyt ΔGDPt ρ ρ C1 a1p ΔGDPt p a 2p Policyt p β1X t ε1t p1 p1 ρ ρ C 2 b1p ΔGDPt p b 2p Policyt p β 2 X t ε 2t p1 p1 Federal Reserve Bank – Atlanta, October 2004 Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Econometric Models • Pro-cyclical Monetary and Fiscal Policy during Good and Bad moments GMM: – Policyt = α0 + α1ΔGDPt*Dgood + α1ΔGDPt*Dbad + α2Policyt-1 + α3Xt + εt, with ΔGDPt-1*Dgood and ΔGDPt-1*Dbad as instrument – VAR Policyt = C + a1ΔGDPt-1*Dgood + a2ΔGDPt-1*Dbad + a3Policyt-1 + βXt + εt ΔGDPt = C + b1ΔGDPt-1*Dgood + b2ΔGDPt-1*Dbad + b3Policyt-1 + βXt +εt Federal Reserve Bank – Atlanta, October 2004 Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Econometric Models • Impact of Capital Flow on Fiscal and Monetary Policy: GMM: Policyt = α0 + α1Capital Flowst + α2Policyt-1 + α3Xt +εt VAR: ρ ρ Policyt C1 a1pCFlow tp a 2p Policytp βXt ε1t p1 p1 ρ ρ ΔCFlowt C2 a 2pCFlow tp a 2p Policytp X t ε 2t p1 p1 Federal Reserve Bank – Atlanta, October 2004 Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Policy Directions and International Capital Influence Argentina Brazil Chile Mexico USA UK Direction GMM P P* C P* C C* VAR P P* C* P* C* C* GMM VAR P* P* P C P* P* P* P* C C P P* GMM VAR P* P* P* P* na na C C C C C* C* GMM P* P* na P C P VAR P* P* na P C P Fiscal Policy Capital Influence Monetary Policy Direction Capital Influence Federal Reserve Bank – Atlanta, October 2004 Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Policy Directions and Capital Influence under Different State Fiscal Policy Direction GMM - Good GMM - Bad VAR- Good VAR - Bad Capital Influence GMM - Good GMM - Bad VAR- Good VAR - Bad Monetary Policy Direction GMM - Good GMM - Bad VAR- Good VAR - Bad Capital Influence GMM - Good GMM - Bad VAR- Good VAR - Bad Argentina Brazil Chile Mexico USA UK C P C P* P* P* P* P C C C* C P P P P* C* P C* C C* P C* C P* P* P* P P C P C P* P P P* P P* P P* C* P* C* P* C P* P P* C P P* P P* P P* P* na na na na C P C P C P C P C* P C* C* P* P* P* P* P* P* P* P na na na na C P C P* C P C* P C P C P Federal Reserve Bank – Atlanta, October 2004 Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Conclusions • Developing countries follow destabilizing pro-cyclical policy. • Data does not show same pattern of pro-cyclical policy in developed countries. • Capital flows seems to affect policy decisions in these economies in a pro-cyclical direction. • Case of Chile indicates that even when capital flows impact fiscal policy in a pro-cyclical direction, if country have an effective savings action during good times, it may be able to implement counter cyclical policy (support to Talvi and Vegh (2000)). Federal Reserve Bank – Atlanta, October 2004 Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Policy Implications • To reduce the chances/impact of pro-cyclical policies: – Increase public savings during good times may reduce chance of pro-cyclical fiscal policy. – Flexibly monetary target during sudden stop may reduce the pro-cyclical aspect of monetary policy. – Prudential regulation in capital mobility may help reduce the destabilizing effect of capital flows. – Development of domestic financial system reduces dependence for international financial flows and so the consequences of the pro-cyclical flows. Federal Reserve Bank – Atlanta, October 2004
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