Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Federal Reserve Bank – Atlanta, October 2004 International Capital Flows and Destabilizing Fiscal and Monetary Policy Jose Ricardo da Costa e Silva Central Bank of Brazil

Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Federal Reserve Bank – Atlanta, October 2004 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”

Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Federal Reserve Bank – Atlanta, October 2004 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 pro- cyclical fiscal policy is one of the reasons for macroeconomic volatility in developing countries, in especial Latin American Countries.

Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Federal Reserve Bank – Atlanta, October 2004 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.

Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Federal Reserve Bank – Atlanta, October 2004 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).

Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Federal Reserve Bank – Atlanta, October 2004

Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Federal Reserve Bank – Atlanta, October 2004 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 Schmidt- Hebbel (2003), Kaminsky, Reinhart and Vegh (2004). –Carvalho (2000), Godfajn (2001), Ocampo (2002, 2003).

Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Federal Reserve Bank – Atlanta, October 2004 Brazil  =0.46

Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Federal Reserve Bank – Atlanta, October 2004 United Kingdon  =-0.11

Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Federal Reserve Bank – Atlanta, October 2004 Literature Review Literature on Pro-cyclical Monetary Policy –Calvo and Reinhart (2000), Caballero (2002a). –Calderon and Schmidt-Hebbel (2003). –Carvalho (2000), Gomez (2001).

Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Federal Reserve Bank – Atlanta, October 2004 Rationale Rationale for Pro-cyclical Monetary Policy –Fixed Exchange Rate –Floating Exchange Rate Floating with inflation-targeting Fear of Floating.

Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Federal Reserve Bank – Atlanta, October 2004 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.

Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Federal Reserve Bank – Atlanta, October 2004 Econometric Models Pro-cyclical Monetary and Fiscal Policy –  GMM: –Policy t = α 0 + α 1 ΔGDP t + α 2 Policy t-1 + α 3 X t +ε t, »with ΔGDP t-1 as instrument –  VAR:

Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Federal Reserve Bank – Atlanta, October 2004 Econometric Models Pro-cyclical Monetary and Fiscal Policy during Good and Bad moments  GMM: –Policy t = α 0 + α 1 ΔGDP t *Dgood + α 1 ΔGDP t *Dbad + α 2 Policy t-1 + α 3 X t + ε t, with ΔGDP t-1 *Dgood and ΔGDP t-1 *Dbad as instrument – VAR Policy t = C + a 1 ΔGDP t-1 *Dgood + a 2 ΔGDP t-1 *Dbad + a 3 Policy t-1 + βX t + ε t ΔGDP t = C + b 1 ΔGDP t-1 *Dgood + b 2 ΔGDP t-1 *Dbad + b 3 Policy t-1 + βX t +ε t

Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Federal Reserve Bank – Atlanta, October 2004 Econometric Models Impact of Capital Flow on Fiscal and Monetary Policy:  GMM: Policy t = α 0 + α 1 Capital Flows t + α 2 Policy t-1 + α 3 X t +ε t  VAR:

Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Federal Reserve Bank – Atlanta, October 2004 Policy Directions and International Capital Influence

Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Federal Reserve Bank – Atlanta, October 2004 Policy Directions and Capital Influence under Different State

Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Federal Reserve Bank – Atlanta, October 2004 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)).

Strategies for Implementing Monetary Policy in the Americas: The Role of Inflation Targeting Federal Reserve Bank – Atlanta, October 2004 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.