Andrés Velasco

Financial crises and balance of payments crises: A simple model of the southern cone experience

Abstract This paper starts from a simple model of the domestic banking sector and develops the potentially destabilizing macroeconomic consequences of its role in intermediating foreign capital inflows. Both financial and balance of payments crises may result, reminiscent of the Southern Cone experience.

Where are we in the Political Economy of Reform

We review the experiences of developing countries with market-oriented reforms, using the tools of modern political economy. We impose intellectual discipline by requiring that actors behave rationally using available information and that basic economic relationships such as budget constraints be accounted for. We attempt to integrate two approaches, one based on dynamic games played by interest groups, with one that focus on limited information and the dynamics of learning. We describe the “starting point” as the set of “old” policies and we attempt to explain the dynamics (political, economic and informational) that lead to reform (section II). We analyze strategies for reformers subject to political constraints (section Ш). We evaluate the aggregate and distributional costs of reforms, emphasizing the importance of looking at the right counterfactuals (section IV). We conclude by pointing to the challenges ahead: the second-stage institutional reforms necessary to take off from underdevelopment.

Monetary policy in a dollarized economy where balance sheets matter

Abstract Does the dollarization of liabilites and the resulting balance sheet vulnerability prevent monetary policy from serving its conventional countercyclical role? We study this question in a model of a small open economy in which domestic firms face an imperfect capital market, with risk premia depending on net worth as in Bernanke and Gertler [Am. Econ. Rev. 79 (1989) 14.]. In spite of the financial fragility channels present in the model, the conventional wisdom still holds: under a floating exchange rate, countercyclical monetary policy does help cushion the impact of foreign real shocks.

The Impossible Duo? Globalization and Monetary Independence in Emerging Markets

Once upon a time it was the impossible trinity—countries could not have capital mobility, an independent monetary policy, and fixed exchange rates all at once.1 Now, according to the conventional wisdom that has emerged after the Mexican,Asian, Russian, and Turkish crises, it is the impossible duo. You cannot enjoy free capital movements and a countercyclical monetary policy, regardless of your exchange rate regime. The culprit, allegedly, is original sin—past misbehavior keeps the country from being able to borrow in its own currency, causing a pervasive dollarization of liabilities. In that context, pundits argue, a monetary expansion accompanied by a real depreciation can do more harm than good, causing debt-service costs to shoot up while bankrupting local banks and firms. Sinful nations that suffer an adverse shock are therefore simply advised to turn the other cheek. Many have, from Hong Kong in 1997 to Argentina today, with predictably painful consequences. So much religion is allegedly uplifting, but the economics behind the emerging orthodoxy is not always clear. This paper argues that the impossibility of the duo is much less clear-cut than the post-Asia discussion suggests. There are indeed situations—particularly if the economy is in the midst of a speculative attack, caused by a bout of pessimism that could be self-fulfilling—in which a policy-induced depreciation may turn out to be lethal. But there are many others—for instance, if the economy suffers an adverse export shock—

How Should Emerging Economies Float Their Currencies

Floating exchange rates seem to be gaining ground in Latin America, East Asia and the transition economies. The recent crises left many economies with no alternative but to float. Others have moved toward floating, searching for greater flexibility and insulation from external shocks. The question for most emerging market economies, then, is no longer to float or not to float, but how to float. Four issues arise in this regard. The first is how to float and have low inflation. The second is whether floating provides as much insulation as conventional theory predicts, especially in the presence of dollarized liabilities. Which leads to the third point: the relationship between the stability of the exchange rate and that of the financial system. The fourth is how to conduct monetary policy under a float, and the role of inflation targeting. We consider each of these points in turn, and conclude that a workable model of how to float seems to be emerging from the so-far successful experience of countries like Chile and Brazil. It involves the adoption of an inflation target as the main anchor for monetary policy, coupled with a monetary policy reaction function that - aside from reacting to the output gap and other determinants of the inflation rate - reacts also partially to movements in the nominal exchange rate.

Financial Frictions and Unconventional Monetary Policy in Emerging Economies

We analyze conventional and unconventional monetary policies in a dynamic small open-economy model with financial frictions. In the model, financial intermediaries or banks borrow from the world market and lend to domestic households. Banks can borrow abroad up to a multiple of their equity; in turn, there is a limit to how much bank equity households can hold. The combination of external and domestic frictions results in an economy-wide credit constraint and an endogenous interest rate spread. It also magnifies the amplitude and persistence of aggregate responses to exogenous shocks. In response to external balance shocks, fixed exchange rates are contractionary and flexible exchange rates expansionary (although less so in the presence of currency mismatches); the opposite is true in response to increases in the world interest rate. Unconventional policies, including central bank direct credit, discount lending, and equity injections to banks, have real effects only if financial constraints bind. Because of bank leverage, central bank discount lending and equity injections are more effective than direct credit. Sterilized foreign exchange intervention is equivalent to lending directly to domestic agents. Unconventional policies are feasible only to the extent that the central bank holds a sufficient amount of international reserves.

Endogenous Financial Dollarization and Exchange Rate Policy

Abstract We develop a simple model of an economy in which domestic agents borrow and lend from each other in either home or foreign currency. Nominal wage rigidity implies that portfolios are chosen to offset the real variability of labor income. Portfolio choices, in turn, affect the potency of monetary policy, and the mapping from exogenous shocks to aggregate outcomes. The model sheds light on the determinants and implications of financial dollarization, its interaction with monetary policy, and other current issues.