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The Impossible Trinity, or,
Why Latin America
Hates QE2
Posted January 19, 2011
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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: Agencia Brasil,
http://commons.wikimedia.org/wiki/File:Guido_mantega.jpg
Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com
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: Malene Thyssen,
http://commons.wikimedia.org/wiki/User:Malene
Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com
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
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
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 importcompetitors 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
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
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
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
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
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_pl
ane.jpg
Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com
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
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