I M F S T A F F D I S C U S S I O N N O T E

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1 I M F S T A F F D I S C U S S I O N N O T E February 29, 2012 SDN/12/01 Two Targes, Two Insrumens: Moneary and Exchange Rae Policies in Emerging Marke Economies Jonahan D. Osry, Aish R. Ghosh, and Marcos Chamon I N T E R N A T I O N A L M O N E T A R Y F U N D

2 INTERNATIONAL MONETARY FUND Research Deparmen Two Targes, Two Insrumens: Moneary and Exchange Rae Policies in Emerging Marke Economies Prepared by Jonahan D. Osry, Aish R. Ghosh, and Marcos Chamon 1 Auhorized for disribuion by Olivier Blanchard February 29, 2012 DISCLAIMER: This Saff Discussion Noe represens he views of he auhors and does no necessarily represen IMF views or IMF policy. The views expressed herein should be aribued o he auhors and no o he IMF, is Execuive Board, or is managemen. Saff Discussion Noes are published o elici commens and o furher debae. JEL Classificaion Numbers: F31; F32; F33 Keywords: Moneary Policy, Foreign Exchange Inervenion Auhors Addresses: 1 We hank Jose de Gregorio, Michel Juillard, Sco Roger, and Mark Sone for useful commens and inpus, and Chrisopher Gibson and Hyeon Ji Lee for excellen research assisance. We are paricularly graeful o Chrisopher Crowe and Mauro Roca for heir work in he preliminary sages of his projec, and o Olivier Blanchard for his guidance hroughou his projec.

3 2 Conens Page Execuive Summary...3 I. Inroducion...4 II. Two Targes, Two Insrumens...5 III. Policies of EME Cenral Banks...7 IV. Effeciveness of Foreign Exchange Inervenion in EMEs...10 V. Inflaion Targeing and Foreign Exchange Inervenion...13 VI. Mulilaeral Consideraions VII. Conclusions References...23 Figures 1. Policy Response o a Demand Shock Policy Response o a Capial Inflow Shock...17 Tables 1. Taylor Rules in Emerging Marke Inflaion Targeers: Panel Regression Change in Reserves as a Funcion of he Change in he REER Sudies on Serilized Inervenion in Emerging Marke Economies...12 Box 1. A Simple Dynamic Model of an Emerging Marke Economy...15 Online Appendix

4 3 Execuive Summary This noe examines he case for using wo policy insrumens he policy ineres rae and serilized foreign exchange marke inervenion in emerging marke counries aiming o mainain low inflaion while avoiding currency movemens ha clearly represen subsanial deviaions of he exchange rae from is medium-run mulilaerally-consisen value. I is ofen said ha paying aenion o he exchange rae can undermine he credibiliy of a commimen o low inflaion. In fac, his argumen has been used o sugges ha counries unwilling o allow a free floaing exchange rae should no adop inflaion argeing (IT) as par of heir policy framework. And as ohers have noed, a number of early adopers of IT made an explici commimen o allow he exchange rae o floa more freely. Bu in counries wih significan currency mismaches in domesic balance shees, high passhrough of he exchange rae o inflaion, and limied iner-secoral facor mobiliy, ignoring exchange rae volailiy can iself prove cosly. And wih emerging-marke counries more limied inegraion wih global financial markes and smaller socks of ousanding localcurrency asses, scope for using serilized inervenion may be greaer. The framework we use o explore hese quesions is unabashedly ad hoc. I makes wo assumpions: ha large deviaions of he real exchange rae from is mulilaerally-warraned value are cosly (e.g., dynamic Duch disease, balance shee effecs), implying ha cenral banks should indeed care abou he exchange rae in addiion o inflaion; and second, ha here is imperfec capial mobiliy/asse subsiuabiliy, and so cenral banks can avail hemselves of boh policy ineres raes and foreign exchange marke inervenion. How should a cenral bank use hese wo policy insrumens o achieve is wo arges? Fully discreionary moneary and exchange rae policies obviously allow maximum flexibiliy in responding o unexpeced shocks. Ye full discreion is no cosless: i may resul in conflicing signals abou he cenral bank s objecives, hus undermining credibiliy. For his reason, our analysis highlighs he benefis for he moneary auhoriy of signaling ha he policy ineres rae will be used o safeguard he primacy of he inflaion arge. Bu if, for example, a sudden surge in capial inflows leads o a large, emporary appreciaion of he currency above is medium-erm value, and ha resuls in economic dislocaion, hen some inervenion in he foreign exchange (FX) marke is likely o be opimal even under an IT regime. The analysis underscores ha such inervenion should only be underaken agains shocks ha move he exchange rae away from is medium-run mulilaerally-consisen value, and ha i should be wo-way, involving boh purchases and sales of FX reserves. Because he cenral bank would be deploying is second insrumen o influence he exchange rae, while adjusing he policy ineres rae o mee is inflaion goal, he wo-arge/woinsrumen regime should no give confusing signals o he public. Moreover, o he exen ha inflows are driven by self-fulfilling expecaions of currency appreciaion, inervenion could help o reduce incenives for carry rade and oher shor-erm capial flows. This noe also briefly considers some mulilaeral aspecs of moneary policy, in paricular he ineracion of policies across emerging-marke economies, and how unilaeral acions compare o cooperaive soluions. Our enaive conclusion is ha an IT regime combined wih FX inervenion insrumens likely dominaes from a global welfare perspecive eiher unilaeral discreion or a narrow IT regime in which he inervenion insrumen is foresworn.

5 4 I. INTRODUCTION I is ofen claimed ha inflaion argeing (IT), o be successful, needs o include a high degree of exchange rae flexibiliy, wih he policy rae geared o sabilizing inflaion and he exchange rae allowed o flucuae freely. The early adopers of IT were very much of his view. Their logic was simply ha, as long as inflaion arges coexis wih oher objecives of moneary policy, ension beween he differen policy goals would be unavoidable. Allowing free floaing was considered by many o be a limus es of a counry s commimen o a credible IT regime for low and sable inflaion (Masson e al., 1997). There are reasons o quesion he logic of his posiion. The crisis has augh us ha policymakers need o deliver more han sable consumer prices if hey are o achieve susained and sable growh, and ha he insrumens a heir disposal include more han jus he policy ineres rae. In he conex of he emerging markes, i has long been recognized and o a degree reinforced by he crisis ha significan balance-shee mismaches imply ha i is rarely opimal o ignore possibly large deviaions of he exchange rae from is medium-run equilibrium, even in an IT conex. On he conrary, reacing o such changes can deliver beer economic oucomes under IT han benign neglec of he exchange rae (Sone e al., 2009). Thus, here are poenially wo policy arges: inflaion and he exchange rae. While emerging marke counries are cerainly much more inegraed in global financial markes han a couple decades ago, heir proneness o experience sudden sops suggess ha his inegraion is far from perfec. Given also heir smaller socks of ousanding localcurrency denominaed asses han mos advanced economies, emerging marke economies have greaer scope for serilized inervenion. This opens up he foruious possibiliy ha policymakers may be operaing in a wo-arge, wo-insrumen world. In his noe, we re-examine he case for using wo policy insrumens (he policy ineres rae and FX marke inervenion) under an IT regime in a sylized emerging marke economy wih disinc srucural feaures. The wo cenral assumpions are ha: firs, large movemens in he real exchange rae away from medium-run equilibrium are cosly (e.g., balance-shee effecs, dynamic Duch disease), so cenral banks should care abou such deviaions as well as inflaion; and second, here is imperfec capial mobiliy/asse subsiuabiliy, so cenral banks indeed have wo insrumens (he policy ineres rae and FX inervenion). Alhough par of he broader policy oolki for insance, in he face of capial inflows macroprudenial policies and capial conrols are no discussed here (see Osry e al., 2010, 2011), hough inervenion migh diminish he case for using emporary conrols on capial inflows. This noe explores he conours of moneary/exchange rae policy in his wo-arge/woinsrumen world. The crux of our argumen is laid ou in he nex secion using he simples possible analyical framework o make our poin. We hen briefly describe how EME cenral banks acually behave in he face of various shocks; specifically, how hey adjus he policy rae and underake FX inervenion in response o movemens in he real exchange rae. Nex we survey evidence on he effeciveness of serilized inervenion in EMEs, since our argumen is predicaed on he cenral bank having wo independen insrumens. While he evidence is mixed, i is a leas suggesive of he cenral bank s scope for influencing he pah of he exchange rae. We hen urn o a sylized model o examine how he cenral bank

6 5 would wish o deploy is wo insrumens in response o shocks under IT wih or wihou serilized FX inervenion (he Online Appendix considers discreionary moneary policies wih or wihou inervenion). Key resuls from he model are ha inervenion should only be used in he face of shocks ha push he currency away from is medium-run warraned value; and ha i should be wo-way (i.e., involving, a differen imes, purchases or sales of official reserves, wih no ne accumulaion or loss). In a penulimae secion, we expand he discussion o consider some mulilaeral issues, arguing ha an IT regime wih use of he FX insrumen would bring he global configuraion of exchange raes closer o heir mulilaerally-warraned ranges han would unconsrained discreion or a narrow IT regime, and his wihou he need for cosly explici policy coordinaion mechanisms. A final secion draws ou he main policy implicaions. II. TWO TARGETS, TWO INSTRUMENTS The global financial crisis has reminded emerging markes, if hey needed reminding, ha capial flows can be highly volaile and ha crises need no be home grown. So how should EME cenral banks reac o various shocks? Leaving aside he (few) cases of formal pegs, he opions for EME cenral banks are (o caricaure a bi) eiher fully discreionary moneary and exchange rae policy or, a he oher exreme, sric IT wih freely-floaing currencies and he policy ineres rae responding only o changes in expeced inflaion. Given ha many EME cenral banks have esablished heir price-sabiliy credenials only recenly (and ofen afer hisories of high inflaion), IT frameworks are generally hough o be useful for guiding policy and mainaining credibiliy. Alhough such frameworks ypically go hand-in-hand wih free floaing in advanced economies, here is no logically necessary reason for hem o do so in EMEs. If EME cenral banks worry abou currency movemens away from mediumrun levels (which, we argue, hey ypically do), hen an IT-cum-serilized-FX-inervenion regime may provide he bes of boh worlds: he discipline of IT wih he exchange rae responsiveness of a managed floa. While EME cenral banks have implicily recognized his long ago, our purpose here is o clarify and formalize he raionale of heir pracice. To fix ideas, i is useful o conras he response of he cenral bank o aggregae demand and capial inflow shocks under alernaive policy regimes. If he economy exhibis divine coincidence (in he sense ha he inflaion arge is consisen wih a zero oupu gap), hen IT would imply ha he policy ineres rae should be lowered in he face of capial inflows or negaive shocks o aggregae demand. Under he floaing exchange rae regime, he cenral bank does no inervene in he FX markes, allowing he exchange rae o appreciae when here are capial inflows and depreciae when here are negaive demand shocks. Bu suppose policymakers are no indifferen o movemens of he exchange rae. As elaboraed below, policymakers may worry abou sharp depreciaions because of he foreign currency exposure of unhedged domesic borrowers, or hey may worry abou appreciaion pressures ha reduce compeiiveness, especially if he currency movemen is a meanrevering deviaion from is medium-run level, and leaves unemploymen and economic dislocaion in is wake. Even if policymakers do no arge a paricular exchange rae level, including because he precise equilibrium value may be difficul o deermine, hey may wish o limi large and abrup movemens in eiher direcion. In oher words, here may be a comfor zone beyond which he auhoriies would no wan o see he exchange rae move.

7 6 If policymakers do care abou he exchange rae, can hey do beer han he sric IT-cumfloaing-exchange-rae regime implies? The answer is yes. Indeed, in his very simple example, here is a clear policy assignmen rule: he ineres rae should be used o mee he inflaion arge, while serilized inervenion should be geared o he exchange rae objecive (see de Gregorio, 2008, for a discussion of he Chilean case). Thus, he policy ineres rae would be lowered in he face of negaive demand shocks bu would no reac o capial flow shocks, while inervenion would be used o resis appreciaion pressures from inflows and depreciaion from negaive demand shocks. Despie is simpliciy, his benchmark model embodies a basic ruh: if policymakers have muliple objecives (which hey surely do), and if he cenral bank has muliple insrumens (which i probably has), hen in general i makes sense o use he full se of available insrumens. While i is difficul o argue agains his poin in he absrac, in our paricular conex, hree objecions can be raised. Firs, ha modern EME cenral banks (like heir advanced-economy counerpars) are largely indifferen o he level of he exchange rae provided hey are meeing heir inflaion objecive. Second, ha cenral banks do no really have wo insrumens because serilized inervenion is ineffecive. Third, ha he flexibiliy afforded by an acive exchange rae policy is no cosless because i poenially sends confusing signals abou he primacy of he inflaion arge, undermining is credibiliy. In he following secions, we ake up he firs wo objecions ha cenral banks are largely indifferen o he level of he exchange rae, and ha hey may have only one effecive policy insrumen. On wheher having a second policy objecive undermines he credibiliy of he inflaion arge, we would argue no provided he cenral bank indeed has wo insrumens. In such a case, explici recogniion of he cenral bank s preferences over he exchange rae migh acually srenghen he credibiliy of he cenral bank s inflaion arge. This is because policy is no made in a vacuum. When he exchange rae moves srongly ou of line wih fundamenals, he cenral bank ineviably comes under pressure o do somehing abou i. Obsinaely refusing o acknowledge he problem and he need for policy adjusmens likely undermines policy credibiliy because he public realizes ha he sance is unenable. By acknowledging ha he exchange rae has moved oo far or oo abruply, and by openly underaking foreign exchange inervenion, an inflaion-argeing cenral bank s claim ha i will respec is inflaion arge arguably becomes more no less credible. A he same ime, i is worh acknowledging ha aiming for an exchange rae ha deviaes subsanially from ha consisen wih medium-erm fundamenals (iself never easy o esimae) may have consequences for inflaion ha ulimaely undermine he cenral bank s inflaion arge. This underscores he imporance of limiing any inervenion o insances where he exchange rae is clearly deviaing from is medium-erm warraned value. Acceping he logic of his argumen sill leaves a number of complicaions ha need o be aken ino accoun. For example, serilized inervenion is no cosless, so he cenral bank will no wan o inervene in arbirarily large amouns especially if he inervenion is no very effecive or he inflows are highly persisen. Moreover, here are radeoffs beween rules (inflaion argeing) and discreion when policy credibiliy is fragile. In secion V, we enrich he discussion o ake accoun of such facors, and show ha, while hey slighly

8 7 modify our conclusions above (for insance, he simple policy assignmen rule no longer holds), hey do no fundamenally overurn hem. Bu firs we esablish ha EME cenral banks ypically do care abou he exchange rae, and ha serilized inervenion is a plausible insrumen in he conex of mos emerging marke currencies. III. POLICIES OF EME CENTRAL BANKS Wha do EME cenral banks do in pracice? Almos ineviably, he exchange rae plays a more imporan role in emerging marke economies han advanced economies, where mos domesic and foreign ransacions are in local currency, markes are deeper, and he privae secor is beer equipped o absorb exchange rae changes. Pass-hrough from he exchange rae o inflaion is ypically higher in EMEs, ofen reflecing more open economies, he currency denominaion of rade, and, a imes, less credible moneary policies. Beyond he effecs on inflaion, given currency mismaches on domesic balance shees (public, financial, corporae, and households), many EME counry auhoriies worry abou sharp depreciaions ha could resul in widespread bankrupcies, fire sales, and economic dislocaion. Finally, given less developed domesic financial markes and he greaer likelihood of credi consrains, firms in EMEs are less able o absorb mean-revering appreciaions of he exchange rae, so he loss of compeiiveness associaed wih a surge of capial inflows is likely o have longer lived effecs. Therefore, even if hey do no se a paricular arge for he exchange rae, mos EME cenral banks have an implici comfor zone beyond which hey would no wan o see he exchange rae move (a leas no abruply), and his is refleced in heir conduc of moneary and inervenion policies (see also he relaed discussion of he rilemma index in Aizenman e al., 2008). Tha is no o sugges ha EMEs should no ry o enhance he economy s resilience o exchange rae movemens for insance, by developing and deepening markes bu such srucural policies ake ime o implemen, and in he meanime, he cenral bank may need o be mindful of sharp currency movemens. Ineres Rae Rules A number of sudies have found ha emerging marke inflaion argeers ofen (implicily) include he exchange rae in heir ineres rae reacion funcion (Taylor rule); see, e.g., Mohany and Klau (2005) and Aizenman e al. (2011). In a exbook IT seing, he exchange rae should only affec an inflaion-argeing cenral bank s ineres rae o he exen ha i has an impac on expeced inflaion. Bu a more pragmaic approach should recognize he imporance of he exchange rae in emerging marke seings (for he reasons explained above), and provide some room for maneuvering wihin he inflaion arge framework. Garcia e al. (2011) presen a model of hybrid inflaion-argeing regimes. Their simulaions suppor he view ha financially robus advanced economies have relaively lile o gain by including he exchange rae direcly in he policy reacion funcion, bu financially vulnerable EMEs migh benefi by doing so in a limied way. These papers do no, however, envisage a sysemaic role for serilized inervenion in IT regimes (see, however, Benes e al., 2012, which models serilized inervenions as an addiional insrumen alongside he Taylor rule and affecing he economy hrough porfolio balance shee effecs in he financial secor). To see wha EME cenral banks do in pracice, Table 1 repors reduced-form Taylor rules for

9 8 a sample of EME IT cenral banks. 2 The explanaory variables include: he lagged dependen variable, since policy raes are adjused slowly; he difference beween expeced inflaion over he nex four quarers (from Consensus Forecas) and he inflaion arge; and he lagged oupu gap (obained from a rolling HP filer). The Taylor rule is augmened o include he deviaion of he log of he real effecive exchange rae from he level implied by a rolling HP filer. Since he regression conrols for expeced inflaion, any effec of he REER on he policy rae will be over and above wha could be jusified by is pass-hrough o inflaion. Table 1, Column 1, only includes he inflaion expecaion deviaion from is arge level as an explanaory variable. No surprisingly, inflaion argeers respond o an increase in inflaion expecaions by raising he real ineres rae; adding he lagged dependen variable (since policy ineres raes are ypically adjused sluggishly) sill yields a posiive coefficien on he expeced inflaion deviaion from arge (Table 1, Column 2). The poin esimae on he global financial crisis dummy is -0.8 percen (his poin esimae would be smaller if oher conrols could capure he collapse in demand), suggesing exraordinary moneary loosening during he crisis. Table 1, Column 3, adds he lagged oupu gap and he change in he real exchange rae. The poin esimae on he oupu gap sugges ha real raes increase by 0.06 percenage poins when oupu is 1 percenage poin above poenial (so a 1.5 percen gap ha persiss for four quarers would raise he policy rae by 0.25 percenage poins). Turning o he variable of ineres, he deviaion of he real exchange rae from is mediumrun value, he poin esimae suggess ha a 10 percen appreciaion of he currency lowers he policy ineres rae by 0.29 percenage poins. 3 This is subsanial, especially as i represens he reacion of he policy rae o he exchange rae over and above any impac of he exchange rae s movemen on expeced inflaion, and considering ha he esimaed coefficien is almos surely smaller han he rue response because of simulaneiy bias. 4 2 The esimaed Taylor rule is given by: * * e * i ( i ) ( ) (log( REER ) log( REER )) YGAP 1 D08:4 09:2, where he dependen variable is he arge real ineres rae (he policy * ineres rae, i minus he four-quarer ahead inflaion arge 4 ) and where REER is he log of he real effecive exchange rae (an increase is an appreciaion of he domesic currency), REER is he level implied by a rolling HP filer, YGAP is he oupu gap, D08:4-09:2 is a dummy variable inended o capure he excepional behavior during he global financial crisis (which had he unusual combinaion of loosening of he policy rae despie sharp depreciaions). The sample of EME IT counries includes: Brazil, Chile, Colombia, Czech Republic, Hungary, Indonesia, Korea, Mexico, Peru, Poland, Romania, Slovak Republic, Thailand and Turkey. Quarerly daa by counry cover he period from IT adopion unil 2010, subjec o availabiliy. 3 Previous sudies had found ha policy ineres raes of emerging marke ITers respond o he exchange rae (e.g., Mohany and Klau, 2005, and Aizenman e al., 2011). Bu by conrolling for expeced inflaion, our esimaes can rule ou he possibiliy ha his is driven by pass-hrough of he exchange rae o inflaion. 4 In addiion o he ineres rae reacing o he real exchange rae (as cenral banks reduce policy raes in response o appreciaion), he exchange rae is likely o respond o he ineres rae. Bu he laer relaionship goes in he opposie direcion: a higher ineres rae will appreciae he real exchange rae, yielding a posiive regression coefficien. The finding of a negaive regression coefficien is herefore despie his simulaneiy bias, and he rue response of he policy ineres rae o he exchange rae is larger (more negaive) han esimaed.

10 9 When we esimae he regression counry-by-counry, he coefficien esimaes are similar o hose presened in Table 1, hough he fewer observaions mean ha some of he coefficiens (especially on REER) are saisically insignifican. Our main conclusions from hese esimaes are ha inflaion-argeing cenral banks in EMEs generally conduc heir ineres rae policy in accordance wih he Taylor principle, ighening real ineres raes when inflaion is expeced o be above is arge or oupu is above is naural level, and more ineresing for our purposes hey respond o real exchange rae movemens above and beyond any impac on expeced inflaion. Table 1. Taylor Rules in Emerging Marke Inflaion Targeers: Panel Regression 1 / Dependen Variable: policy rae - inf. Targe (1) (2) (3) Lagged (policy rae - inflaion arge) *** *** [0.039] [0.046] Expeced inflaion - inflaion arge *** *** *** [0.168] [0.097] [0.094] REER deviaion from rend *** [0.009] Lagged oupu gap * [0.030] Dummy for global financial crisis *** *** [0.438] [0.251] [0.286] Consan *** *** *** [0.081] [0.097] [0.113] Observaions R-squared Number of Counries / Sandard errors in brackes. *, ** and *** denoe saisical significance a he 10, 5 and 1 percen level, respecively. REER is defined such ha an increase denoes an appreciaion of he currency. Foreign Exchange Inervenion Turning o foreign exchange marke inervenion, a simple albei imperfec saisic of he degree of inervenion is he sandard deviaion of he change in reserves relaive o he sum of he sandard deviaions of he change in reserves and of he change in he real exchange rae; his saisic ranges from zero (a pure floa, no inervenion) o uniy (all shocks o he REER are perfecly smoohed). 5 For emerging marke inflaion argeers, he saisic is 0.63, which is no only posiive bu in fac no even appreciably lower han for EME cenral banks ha do no have explici inflaion-argeing frameworks (whose inervenion saisic is 0.73). 5 The sample of non-inflaion-argeing EMEs used here is Argenina, Cosa Rica, Croaia, Dominican Republic, India, Kazakhsan, Malaysia, Russia, Sri Lanka, and Uruguay. Specifically, we calculae /( ) Reserves Reserves REER

11 10 Table 2 repors he resul of a regression of change in inernaional reserves on he log deviaion of he REER from he level implied by a rolling HP filer. The firs column repors he resuls for our sample of inflaion argeers. The poin esimae suggess a 10 percen appreciaion of he currency would be associaed wih a 3.8 percen increase in reserves (again, his is probably an underesimae because simulaneiy will end o bias our esimaes oward zero). 6 Table 3 (column 2) also repors analogous resuls for a comparaor sample of non-it counries since 2000, which have an even sronger response: 14.1 percen. 7 The boom line seems o be ha inflaion-argeing cenral banks in EMEs do inervene acively in he foreign exchange marke (alhough raher less aggressively han heir non-it counerpars), and cerainly do no follow freely floaing exchange rae regimes. Table 2. Change in Reserves as a Funcion of he Change in he REER 1 / Change in Reserves IT Non-IT OLS OLS REER deviaion from rend ** *** [0.156] [0.321] Dummy for global financial crisis * *** [4.410] [4.681] Consan *** *** [0.388] [0.446] Observaions R-squared Number of counries / Sandard errors in brackes. *, ** and *** denoe saisical significance a he 10, 5 and 1 percen level, respecively. An increase in he REER denoes an appreciaion of he currency. IV. EFFECTIVENESS OF FOREIGN EXCHANGE INTERVENTION IN EMES The argumen ha even inflaion-argeing EME cenral banks migh inervene o bring currency values closer o medium-run equilibrium is premised on FX inervenion being an effecive policy ool. There is lile quesion ha unserilized inervenion is effecive in moving he exchange rae. Bu if i is only unserilized inervenion ha works, hen he 6 In addiion o he cenral bank purchasing foreign exchange reserves in he face of currency appreciaion, he exchange rae will reac o inervenion. Bu his relaionship goes in he opposie direcion: cenral bank purchases of foreign exchange will end o depreciae he exchange rae, yielding a negaive coefficien. The finding of a posiive regression coefficien is herefore despie his simulaneiy bias, and he rue response of foreign exchange inervenion o an exchange rae appreciaion is larger (more posiive) han esimaed. 7 As in he case of he Taylor rule, resuls are very similar if we use he year-on-year change in he REER insead of his measure of deviaion from rend. The poin esimae for he IT sample declines from 0.38 o 0.35, while ha for he non-it sample declines from 1.41 o 1.07.

12 11 cenral bank would no have wo policy insrumens and our argumen breaks down. Wha hen is he evidence ha serilized inervenion (i.e., purchases and sales of foreign exchange ha leave he cenral bank s ineres rae unchanged) has an effec on he exchange rae? There are wo main ways hrough which serilized inervenion can affec he exchange rae: he porfolio balance and he signaling channels. The former sems from he change in he relaive supply of domesic and foreign currency asses following he inervenion. If boh ypes of asses are perfec subsiues (i.e., if uncovered ineres pariy holds), hen changes in relaive supply would no affec he exchange rae. Bu under imperfec subsiuabiliy, he exchange rae adjuss as invesors demand compensaion o shif heir porfolio holdings oward he asse ha has become relaively more abundan. There are reasons o be skepical abou he quaniaive imporance of his channel in he case of advanced economies, where bond markes are so huge ha even massive inervenion barely makes a den on he relaive supply of asses (Ghosh, 1992). In he case of EMEs, however, inervenions can amoun o a significan share of local bond markes, and his channel can be sronger. The signaling or expecaion channel affecs he exchange rae hrough a change in marke expecaions abou fuure fundamenals (including he sance of moneary policy). If he cenral bank has beer informaion abou fundamenals (which is cerainly he case, a leas regarding he fuure sance of moneary policy), hen inervenion can be perceived as a signal of fuure exchange rae movemens. Unlike he porfolio balance channel, i is no clear a priori wheher his channel should be sronger in EMEs or advanced economies. Sone e al. (2009) survey inervenion pracices as of lae 2007, including in 14 inflaionargeing EMEs. Excess volailiy is a moivaion for inervenion in eigh of hose EMEs, wih hree ohers having volailiy-relaed moives (e.g., sabilize foreign exchange markes, mainain orderly condiions, and mainain exchange rae sabiliy). Oher common moives include reserve managemen (e.g., accumulaion of reserves for prudenial reasons) in five EMEs, managing he exchange rae so as o help achieve he inflaion arges in wo EMEs, managing he exchange rae wihin a band in wo cases, and signaling in one EME. Adler and Tovar (2011) survey official cenral bank saemens for he moives of inervenion in 15 economies, wih a focus on Lain America. The wo reasons mos ofen saed are building inernaional reserve buffers and conaining exchange rae volailiy. Only one counry saed ha slowing he speed of appreciaion was a moive. There are few empirical sudies on he effeciveness of serilized inervenion specifically in EMEs; several individual counry sudies are surveyed in Disyaa and Galai (2005). 8 Guimarães and Karacadag (2004), using inervenion daa from Mexico and Turkey, find ha foreign exchange sales have a small bu saisically significan effec on he level of he exchange rae in Mexico, bu no in Turkey; hey also find ha such inervenion reduces exchange rae volailiy in Turkey (bu no in Mexico). Alhough mehodological differences across sudies makes comparisons difficul, on he whole, evidence ha such inervenion can 8 BIS Paper no. 24 (2005) has a series of background papers and conribued papers from differen cenral banks from a conference of Depuy Governors hosed by he BIS on foreign exchange marke inervenion.

13 12 affec he level of he exchange rae ends o be weaker han evidence ha i can affec exchange rae volailiy, bu for boh, mos sudies find a leas some impac (Table 3). The effeciveness of serilized inervenion is also likely o depend upon he circumsances. Kamil (2008) finds ha inervenions were effecive in affecing he exchange rae in Colombia when done during a period of moneary easing (alhough he quaniaive effecs were small and shor-lived), bu no during a period of overheaing and moneary ighening. Sone, Walker and Yosuke (2009) show ha serilized inervenion in Brazil in he immediae afermah of he global financial crises helped sabilize marke expecaions of exchange rae volailiy. Adler and Tovar (2011) esimae he effec of inervenion on a panel of 15 economies, wih a focus on Lain America. They find ha inervenions can slow he pace of appreciaion. Inervenions are less effecive in counries wih more open capial accouns, and more likely o be effecive in he conex of already overvalued exchange raes. Overall, he evidence on he effeciveness of serilized inervenion in EMEs is mixed, bu generally more favorable han in he advanced economy conex. The very fac ha many, if no mos, EME cenral banks underake serilized inervenion suggess ha a leas hey believe i o be effecive in heir own currency markes. Moreover, in assessing effeciveness, i is imporan o bear in mind he policy goal. To he exen ha inervenion is successful in reducing volailiy and limiing shor-run movemens, his may be all ha is required o help couner he effecs of emporary surges in capial inflows o EMEs. Accordingly, in wha follows, we assume ha he cenral bank has available boh is policy ineres rae and serilized inervenion as effecive insrumens. Table 3. Sudies on Serilized Inervenion in Emerging Marke Economies Sudy Counry Level Effeciveness on Volailiy Sone, Walker, and Yosuke (2009) Brazil Yes Yes Tapia and Tokman (2004) Chile Yes Mandeng (2003) Colombia Yes (mixed) Kamil (2008) Colombia Yes (weak) Yes Holub (2004) Czech Republic Mixed Disyaa and Galai (2005) Czech Republic Yes (weak) No Barabás (2003) Hungary Mixed Paanaik and Sahoo (2003) India Yes (weak) Yes Rhee and Song (1999) Korea Yes Domaç and Mendoza (2002) Mexico and Turkey Yes Yes Guimarães and Karacadag (2004) Mexico and Turkey Yes (weak) Mixed Abenoja (2003) Philippines Mixed Yes (mixed) Sangmanee (2003) Thailand No Adler and Tovar (2011) Mainly Lain America Yes

14 13 V. INFLATION TARGETING AND FOREIGN EXCHANGE INTERVENTION Given is objecives of mainaining low inflaion and avoiding large movemens in he exchange rae away from medium-run equilibrium, wha is he bes policy regime for an emerging marke cenral bank? While fully discreionary moneary and exchange rae policies allow maximum flexibiliy, hey can also send confusing signals abou cenral bank objecives ha may ulimaely undermine policy credibiliy. For his reason, he cenral bank may op for an IT regime, subordinaing is moneary policy o achieving he inflaion objecive. If, as he discussion above suggess, EME cenral banks also have available a second insrumen (foreign exchange inervenion), hey can also limi emporary movemens of he exchange rae wihou prejudicing aainmen of heir primary arge, he inflaion rae. Building on he discussion from secion II, here we consider how he cenral bank would respond o various shocks in a small open economy model of an emerging marke economy wih imperfec capial mobiliy, such ha capial flows respond posiively o he ineres differenial (aking accoun of any expeced appreciaion of he currency), bu a a finie pace. The cenral bank s objecives, which are assumed o be he same regardless of he policy regime, are hreefold: o minimize he deviaion of inflaion from is arge, o minimize he oupu gap around he economy s poenial level of oupu, and o minimize he deviaion of he exchange rae from is level implied by medium-erm fundamenals. The laer reflecs concerns abou compeiiveness on he appreciaion side, and balance shee risks of unhedged foreign currency exposure on he depreciaion side. 9 In addiion, recognizing ha here are coss o holding reserves, he cenral bank is assumed o minimize is accumulaion of excess reserves (relaive o he coverage required for counry-insurance purposes). Under discreionary policies, he cenral bank is unable o commi no o ry o inflae he economy above is non-acceleraing inflaion poenial; a measure of he cenral bank s (lack of) credibiliy is he public s percepion of is incenive o do so. The laer, which impars an inflaionary bias and which he cenral bank is assumed o ake as given, is modeled as depending on he inflaion performance of is economy. Under IT, by conras, he cenral bank commis o a lexicographical ordering of objecives such ha is inflaion arge is always me (in he sense ha arge and expeced inflaion are equal). This keeps inflaionary expecaions firmly anchored hroughou, so here is no inflaionary bias under IT. Wih his seup, i is possible o race hrough he cenral bank s reacion o various shocks under alernaive policy regimes. In he Online Appendix, we provide analyical soluions for he key resuls in a simple wo-period version of he model, as well as comparing all four policy regimes: discreionary moneary policy wih or wihou FX inervenion, and IT wih or wihou inervenion. Here we focus on he comparison of he wo IT regimes: wih and wihou FX inervenion in a dynamic version of he model (presened in Box 1). 9 The cenral bank s objecive can be specified as penalizing he (log) level deviaion of he real exchange rae or is rae of change. Though concepually disinc, i makes lile qualiaive difference o he simulaions as in eiher case he cenral bank seeks o limi he movemen of he exchange rae. The repored simulaions assume he argeing of he level of he real exchange rae around he value implied by medium-run fundamenals.

15 14 We begin by considering he impac of a posiive aggregae demand shock, equivalen o one percenage poin of oupu, ha occurs in period 1 and dies ou gradually (see Figure 1). In he face of such a shock, he moneary auhoriies would naurally reac by raising he policy ineres rae. Comparing he ineres rae response across regimes shows ha he cenral bank would raise ineres raes by more when i also inervenes in he FX marke (red line) han when i does no (black line). Higher policy ineres raes, which help couner he demand shock, also lead o capial inflows, puing upward pressure on he currency. If he cenral bank can inervene in he FX markes, hen i is able o raise ineres raes by more han if i does no inervene. Moreover, despie raising ineres raes by less when i does no also inervene, he cenral bank mus olerae a more appreciaed currency. Alhough reserves iniially increase, hey subsequenly decline, evenually reurning o heir baseline value (normalized o zero). As such, he opimal policy does no imply susained one-way inervenion, bu insead boh sales and purchases of reserves along he adjusmen pah. In he face of a capial inflow shock (modeled as a decline in foreign ineres raes, which is gradually reversed; see Figure 2), he cenral bank would lower he policy ineres rae, hereby reducing he incenive for capial o cross he border. Again, comparing he ineres rae response across regimes shows ha he cenral bank would lower ineres raes by less when i also inervenes in he FX marke. This is because in he absence of inervenion he only insrumen he cenral bank has o dampen incenives for capial inflows is o lower policy raes. Bu despie he lower policy ineres rae, he cenral bank is forced o accep a more appreciaed exchange rae (relaive o ha warraned by medium-erm fundamenals) when i does no inervene in he FX marke. 10 And again, inervenion is wo-way: iniial purchases of FX, followed by sales, wih no ne seady-sae change in he sock of reserves. Moreover, regardless of he shock, he IT framework ensures ha he cenral bank mees is inflaion arge, so inervenion does no prejudice meeing he arge. Bu wihou FX inervenion, in boh cases he cenral bank mus olerae a more appreciaed currency (and, conversely, wih negaive shocks, a more depreciaed one), lowering welfare relaive o is objecive of keeping he exchange rae close o is fundamenal value. Thus, even hough inervenion iself is assumed o be cosly, he welfare implicaion is clear: having boh he policy ineres rae and FX inervenion as insrumens dominaes having only he policy rae. Moreover, as discussed in he Online Appendix, because he economy exhibis divine coincidence, he welfare gain from he flexibiliy of fully discreionary moneary policy (as opposed o IT) is small, and if he cenral bank s credibiliy is fragile, may even be negaive. The more imporan gain comes from having he second insrumen, FX inervenion. Is his a general resul? The answer is yes, hough he exen of he welfare gain from having he inervenion insrumen depends on he naure and characerisics of he capial inflows. Two parameers are key: he ineres rae sensiiviy of capial flows ( r ) and he persisence 10 A furher comparison is beween IT and discreion. As shown in he Online Appendix, under discreionary policies, he cenral bank reduces he policy rae more aggressively, bu inervenes less aggressively, ending up wih a larger oupu gap bu less real exchange rae appreciaion. In each case, he level of foreign reserves reurns o is baseline value (normalized a zero), so neiher shock calls for one-way susained inervenion.

16 15 Box 1. A Simple Dynamic Model of an Emerging Marke Economy To simulae policy responses, we adop a dynamic version of he simple EME macroeconomic model laid ou in he Online Appendix. All variables are expressed in logs, excep for ca, which is defined as he curren accoun balance as a raio o he foreign liabiliy posiion, k; all parameers (Greek leers) are posiive. Capial flows are specified as a parial adjusmen process, converging o a finie sock for a given expeced reurn differenial: k ( ) r r r E e 1 kk 1 Where e is he real exchange rae (an increase is an appreciaion), r and r* are he domesic and foreign real ineres raes. In a world wihou fricions, he capial sock should adjus insananeously, arbiraging away any expeced reurn differenial. Bu we assume uncovered ineres rae pariy (UIP) does no hold (as is he case in pracice, where if anyhing, a currency ends o appreciae in he presence of an ineres rae differenial, he forward premium puzzle). The foreign real ineres rae follows an AR(1) process: r r * * r 1 The curren accoun is given by: ca e e y y The balance of paymens (BOP) equaion is given by: The Phillips curve for domesic inflaion is given by: E 1 y, ca k R (where =R/k). Aggregae demand (he IS curve) depends on he real exchange rae and he real ineres rae: y r e u, r e where he shock is an AR(1) process wih parameer u. The cenral bank s objecive funcion depends on he oupu gap, inflaion, he deviaion of he real exchange rae from is mulilaerally-consisen level (normalized o zero), and he deviaion of reserves from heir opimal seady-sae level (say based on counry-insurance merics): min EPDV (( y e y ) a be cr ) rr, e where y is he public s esimae of he cenral bank s inflaionary bias. We calibrae he model assuming he following iniial raios and parameers: 0.15; r 1; k 0.5; 1; 0.5; 0.99; * 0.75 r y 0.3; r 1; e 0.25; u 0.75 a 1; b 0.1; c 0.01 Finally, in he discreionary policy regimes, he public secor s esimae of he inflaion bias is calibraed so as o generae inflaionary expecaions equal o 0.9 imes he previous period s inflaion rae, and se equal o zero in he IT regimes.

17 16 Figure 1. Policy Response o a Demand Shock 1/ Policy Ineres Rae (percen per year) Reserves (percen deviaion from seady-sae) Inflaion (percen per year) 4 Real Exchange Rae 2 / (percen deviaion from seady-sae) Oupu Gap (percen deviaion from seady-sae) 2.5 Shock o Domesic Demand (percen deviaion from seady-sae) IT wih FX inervenion IT (no FX inervenion) 1/ The shock is based on a 2.5 percenage poin increase in domesic demand. 2/ An increase in he exchange rae is an appreciaion of he domesic currency.

18 17 Figure 2. Policy Response o a Capial Inflow Shock 1/ 0.5 Policy Ineres Rae (percen per year) 5 Reserves (percen deviaion from seady-sae) Inflaion (percen per year) 8 Real Exchange Rae 2 / (percen deviaion from seady-sae) Oupu Gap (percen deviaion from seady-sae) 5 Capial Inflow (cumulaive flow) IT wih FX inervenion IT (no FX inervenion) 1/ The capial inflow shock is based on a 5 percenage poin decline in he world ineres rae. 2/ An increase in he exchange rae is an appreciaion of he domesic currency.

19 18 of capial inflows (which depends on * ). As capial flows become more sensiive o he r reurn differenial, serilized inervenion becomes more difficul (a given quaniy of inervenion has a smaller impac on he exchange rae); in he limiing case of perfec capial mobiliy ( r ), serilized inervenion becomes impossible. No surprisingly, herefore, greaer sensiiviy of capial flows o he reurn differenial means ha he cenral bank mus olerae a higher real appreciaion and proporional o he capial flow -1.0 underake less inervenion (ex char). The absolue amoun of reserve -1.5 accumulaion is non-monoonic in he -2.0 reurn sensiiviy of capial flows, r. When his sensiiviy is small, he iniial change -2.5 in reserves is also small (since he reurn -3.0 differenial has lile implicaions for inflows). As r increases, FX inervenion -3.5 iniially increases, bu evenually sars o decline (since inervenion becomes ineffecive as r ). Policy Response and Sensiiviy of Inflows wih Respec o 0.0 Reurn Differenial Policy Ineres Rae (LHS) Reserve Inervenion/Iniial Capial Inflow (RHS) Sensiiviy of Inflows wih Respec o Reurn Differenial (γ r ) Conversely, he greaer he responsiveness of capial flows o he reurn differenial, he more he policy rae is lowered. In oher words, as he economy moves oward he limiing case of perfec capial mobiliy and asse subsiuabiliy, he cenral bank mus increasingly rely on ineres rae changes raher han FX inervenion o influence he exchange rae. The simulaions ake he rae of reurn sensiiviy of capial flows as given and consan across regimes; in pracice, i may vary wih he policy regime. In paricular, greaer cerainy on he par of invesors ha hey will obain a higher rae of reurn would likely increase he sensiiviy of capial flows o he reurn differenial. I is noeworhy in his regard ha, in mos of he simulaions (including hose depiced here), he response o a capial inflow shock is o allow a jump in appreciaion of he real exchange rae (albei smaller han in he absence of inervenion) followed by a gradual depreciaion. In oher words, he opimal inervenion ypically does no offer invesors a sure expeced appreciaion precisely because doing so would induce greaer capial inflows, which is wha he cenral bank wans o avoid. Neverheless, he regimes wih FX inervenion generally imply somewha higher and more persisen expeced reurns compared o he regimes wihou FX inervenion. 11 I is possible, herefore, ha knowing he cenral bank had adoped a policy regime ha included FX inervenion (and herefore higher and more persisen reurns in he even of capial inflow shocks), invesors would become more responsive o he reurn differenial (an 11 For example, he expeced reurn (inclusive of he ineres rae differenial and expeced depreciaion) over periods 1 10 averages 2.1 percen under IT wih FX inervenion, and 1.8 percen under IT wihou inervenion.

20 19 increase in r ), rendering serilized inervenion less effecive. 12 To reduce his endency, some uncerainy in he cenral bank s inervenion policy when, how much, and a wha exchange rae level may be useful (hough in deciding how much randomness o incorporae in is inervenion policy, he cenral bank needs o be mindful of is impac on he real economy). In paricular, he cenral bank should no be viewed as defending a specific level of he exchange rae, and should be perceived as willing o le i depreciae when inflow pressures abae. Such shor-run volailiy in he reurn o invesors can help counerac he percepions of one-way bes. 13 The oher key parameer is he persisence of he capial inflows. The less persisen he shock o he foreign ineres rae, he less persisen he inflows ha would occur in he absence of any policy response, and he smaller he policy response. The key insigh of his experimen, however, is ha as a percenage of he iniial capial inflow he iniial inervenion (i.e., accumulaion of reserves) is greaer when inflows are expeced o be less persisen. In fac, he degree of inervenion (as a percenage of iniial inflows) is monoonically decreasing in he expeced persisence of he inflows (ex char). Moreover, when he shock is more persisen, he policy ineres rae will be lowered by more, hus playing a larger role relaive o FX inervenion. This accords wih he usual inuiion ha he auhoriies should allow he economy o adjus o permanen shocks (including capial inflows) bu inervene o absorb emporary shocks ha move he economy away from is medium-erm equilibrium Policy Response and Persisence of Inflow Shock Reserve Inervenion/Iniial Capial Inflow (RHS) Policy Ineres Rae (LHS) Persisency of Shock o Inflow (ρ r* ) The discussion above perains o capial inflows, hough many of he same argumens apply o when here are ouflows (he response o an ouflow shock is he mirror image o he response o an inflow shock of a similar magniude). In he face of emporary capial ouflows, he cenral bank would raise policy ineres raes o keep he oupu gap a zero (and inflaion a is arge level), raising hem more aggressively in he non-fx inervenion regime. Despie he more aggressive ineres rae policy, he cenral bank would need o The converse is also possible: if capial inflows are responding o self-fulfilling expecaions abou exchange rae appreciaion, hen knowledge ha he cenral bank would inervene o limi he appreciaion migh reduce capial inflows (and hence he need for acual inervenion). 13 Randomizaion can be cosly o he cenral bank, since is loss funcion penalizes he volailiy of reserves and of he exchange rae. Suppose he cenral bank has he IT regime wih FX inervenion and is responding o he shock in Figure 2. If i were o add a normally disribued shock o is opimal reserve policy wih a sandard deviaion of 2.5 percen, he resuling disribuion of expeced reurns would have a sandard deviaion of 1.4 percen. While his should discourage inflows, is adverse effec on welfare would be equivalen o he impac of capial inflows resuling from a furher 125 basis poin decrease in he world ineres rae.

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