Chapter

Chapter 2. A Historical Perspective on Central Banking in Latin America

Author(s):
Luis I. Jacome H., Yan Carriere-Swallow, Hamid Faruqee, and Krishna Srinivasan
Published Date:
October 2016
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Author(s)
Luis I. and Jácome H. 

The primary goal of this chapter is to analyze the historical evolution of central banking in Latin America that will serve as the backdrop for the rest of the book. The chapter describes the evolving institutional arrangements and policy frameworks since the foundation of Latin American central banks in the 1920s as the key drivers of monetary policy. It highlights the fact that monetary policy did not render good results in terms of inflation until the 2000s, when central banks had a clear policy mandate and were granted political autonomy.

Following Jácome (2015), this historical journey distinguishes three main periods: (1) the early years, which span from the 1920s, when countries in the region endorsed the gold standard, up to the end of the Second World War; (2) the developmental phase, which spans from the postwar period to the early 1990s, when central banks turned into development banks under the aegis of the government; and (3) the golden years, covering the last 20 years, when central banks enjoyed political autonomy and achieved price stability.

The chapter also identifies transitory stages that emerged between these three periods. First, the collapse of the gold standard in the early 1930s left monetary policy in an interregnum, as the convertibility of domestic currencies was abolished. This transitory period lasted until the Bretton Woods system reestablished the convertibility of currencies in the mid-1940s, this time vis-à-vis the U.S. dollar—and through this to gold. A second interim period emerged following the breakdown of Bretton Woods in the early 1970s, as the convertibility of the U.S. dollar to gold was abandoned and countries were free to choose any exchange rate regime. This transitory phase was replaced by a new paradigm in the 1990s, when central banks were granted political autonomy to focus on fighting inflation in an environment of exchange rate flexibility and open capital accounts.

Central banks in Latin America may enter into a new transition, one that is already in progress in advanced economies in the wake of the global financial crisis. The new central bank blueprint stresses an enhanced role for central banks in preserving systemic financial stability and fostering economic activity.1 As in the past, central banks in Latin America are likely to follow this trend. Several central banks in the region also face the challenge of preserving monetary policy independence in a world of highly volatile capital flows.

The next section of this chapter provides a historical perspective of the changes in the institutional foundations of monetary policy in Latin America. That is followed by a description of the evolving monetary policy framework throughout the three periods considered. The chapter then maps the institutional and policy changes of central banking to the historical performance of inflation in Latin America, before offering some concluding remarks.

The Evolving Institutional Foundations of Monetary Policy

The first central banks in Latin America were founded in the 1920s. The institutional basis for monetary policy reflected the rules of the gold standard prevailing at that time,2 and the political economy behind the creation of central banks with the monopoly of currency issue (Box 2.1). From then on, central banks’ institutional underpinnings varied over time, mainly in response to domestic factors but also due to the influence of international academic trends. This section analyzes how monetary policy in Latin America has changed historically in response to the evolving mandates and governing arrangements of central banks over the years.

Mandate

The mandate of central banks in Latin America changed significantly over time (Figure 2.1). In most countries, central banks were initially assigned multiple functions with a view of fulfilling three main goals: (1) maintain monetary stability; (3) finance the government on a limited basis; and (3) help preserve a sound banking system (Appendix 2.1). Monetary stability would result from an orderly currency issuance associated with the rules of the gold standard, which would also secure a stable exchange rate and, ultimately, an environment of low inflation.3 Central bank financing to the government, although allowed, was constrained by legislation in order to avoid previous episodes of generous—often forced—financing to the government by private banks that enjoyed the privilege of issuing local currency. In turn, by requiring commercial banks to be on a sound financial footing as a condition to benefit from rediscount operations, central banks contributed to maintaining financial stability.4 With the same purpose, central banks were assigned functions as lender of last resort. When commercial banks faced liquidity shortages, central banks were empowered to supply liquidity, provided the impaired bank was solvent according to the banking authority. Banking regulation and supervision was assigned to a different agency, as central banks were primarily given monetary policy responsibilities—the “Pacific model” as described in Jácome, Nier, and Imam (2012)—with only limited regulatory powers.

Figure 2.1.The Evolving Mandate of Central Banks in Latin America

Source: Prepared by the author.

Box 2.1.The Origins of Central Banking in Latin America

The first central banks in Latin America were established at the time when a worldwide consensus had been reached about the need for all countries to have a central bank. The first central bank was the Reserve Bank of Peru, founded in 1922, followed by the Bank of the Republic of Colombia created in 1923. Chile and Mexico established their central banks in 1925, followed by Guatemala, Ecuador, and Bolivia in 1926, 1927, and 1929, respectively. Important sources of impetus for the creation of central banks were the Brussels International Financial Conference in 1920 and the Genoa Conference in 1922, which recommended that countries endorse the gold standard. Since these central banks adhered to the gold standard, they committed to maintaining the convertibility of their currencies.

There had been several failed attempts to create central banks in Latin America before external experts were brought to the scene to provide informed advice. This is not surprising, since giving the central bank the monopoly of currency issue affected vested economic interests associated with the power to legally issue bank notes, which in turn granted banks’ shareholders strong political influence. To overcome this gridlock, foreign experts were often called in to provide their knowledge and credibility to the reform process involving the creation of central banks. The various Kemmerer missions during the 1920s and early 1930s played this role in Colombia, Chile, Ecuador, Bolivia, Guatemala, and in Peru to reform the existing central bank.1 The recommendations were the same for all countries, namely the creation of a central bank with the monopoly of currency issue, endorsement of the gold standard in order to stabilize the value of local currencies, introduction of bank legislation to regulate and supervise banks by a separate agency, and reform of public finances to make them consistent with the goal of preserving the stability of the currency.

1 Edwin W. Kemmerer was an economics professor at Princeton University who led missions of experts to seven Latin American countries between 1917 and 1930 to advise on monetary and financial sector issues.

Following the collapse of the gold standard in the early 1930s, central banks in Latin America—like in the rest of the world—were no longer committed to maintain the convertibility of domestic currencies. During these years, a second group of central banks was established, including banks in El Salvador (1934), Argentina (1935), and Venezuela (1939).5 Central bank legislation was adjusted to the new conditions that followed the collapse of the gold standard. Without having to maintain the convertibility of the currency, the Central Bank of the Republic of Argentina had more leeway to issue money and, therefore, had the mandate to regulate the amount of money and credit (Appendix 2.1). The Central Reserve Bank of El Salvador featured a similar mandate. The Central Bank of the Republic of Argentina was also required to build up international reserves to cushion the impact of adverse external shocks, and was a pioneer in having a mandate to preserve the value of the currency. In addition, it was the first central bank charged with banking regulation and supervision on top of its monetary responsibilities. Other countries in the region subsequently established similar organizational setups (Brazil, Paraguay, and Uruguay) referred to as the “Atlantic model” in Jácome, Nier, and Imam (2012).

A new period of central banking started with the end of the Second World War and the establishment of the Bretton Woods accord. The new international monetary system was based on the convertibility of the U.S. dollar into gold at a fixed value. In a broader context, Keynesian ideas were quite influential at that time, leading to greater government participation in the economy. Government intervention also reached into monetary policy, which was used to finance fiscal expenditure and support import-substitution industrialization, the development strategy adopted by several Latin American countries.

New central banks were created and a wave of central bank reforms took place during this period. New central banks included those in Cuba and the Dominican Republic in the 1940s, and Costa Rica, Honduras, Nicaragua, and Paraguay in the 1950s. In the 1960s, the Central Bank of Brazil and the Central Bank of Uruguay finally became stand-alone central banks.6 They were typically assigned the responsibility of formulating monetary, credit, and exchange rate policy, with the aim of supporting economic activity and also preventing inflation. In turn, central bank reforms reflected a general sense that previous legislation imposed constraints on the new economic strategy by limiting governments’ influence on monetary policy.7 Like before, some of these reforms followed recommendations made by external experts. In particular, Robert Triffin, from the U.S. Federal Reserve, influenced the reform adopted in Guatemala in the mid-1940s and later in Ecuador, and the creation of central banks in the Dominican Republic, Honduras, and Paraguay.8 Triffin was opposed to the passive character of monetary policy embedded in the previous laws, which had worked as an amplifier of external shocks. Instead, he proposed legislation to support economic development and to allow central banks adopt countercyclical policies to mitigate a volatile external environment.

In practice, central banks became, to a great extent, development institutions focused on promoting economic activity and financing the government at the expense of being more tolerant about inflation. While some of the new laws also made references to inflation (for example, requiring central banks to “prevent inflationary and deflationary trends”), the overriding policy objective of monetary policy was, in general, to promote economic development. Such was the case, for example, in Chile, Colombia, and Peru. In Argentina, the central bank mandate shifted to preserving a high level of employment and the purchasing power of the currency. For its part, the Bank of Mexico was required to formulate monetary, credit, and exchange rate policies with the triple objective of promoting the stability of the purchasing power of money, financial system development, and sound economic growth (Appendix 2.2).

The temporary suspension of the Bretton Woods monetary system in 1971 marked the beginning of an era when countries were allowed to choose their exchange rate regime. A new transitory period started. In some countries in Latin America—in particular in the Southern Cone—governments implemented populist macroeconomic policies with the support of accommodative monetary policies.9 For example, in Argentina, the government introduced a far-reaching reform that included the nationalization of the banking system and a new central bank law that put monetary policy under complete government control. The central bank provided credit to the private sector under specific government guidance with the view of “increasing production and securing the highest standard of living and collective happiness.”10 In Chile, following the demise of the socialist government in 1973, a new central bank law was enacted that put monetary policy under government control—although not with a populist character. While macroeconomic instability spread to most countries in the region during the 1980s, no major changes in the central banks’ mandate took place in that decade.

The 1990s marked a turning point for monetary policy in Latin America. After more than 50 years during which central banks were tasked with multiple mandates and governments had influence in their policy decisions, central banks were granted political and operational autonomy to focus primarily—and even exclusively—on abating inflation (Appendix 2.3). Thus, central banks were no longer directly responsible for output growth. Instead, monetary policy would aim at securing low and stable inflation—to reduce uncertainty in consumers’ and investors’ decisions—as a precondition to achieving sustainable economic growth. Fiscal policy helped in this endeavor. Breaking with the past, governments started to keep public sector deficits in check, without resorting to central bank financing—the main historical source of inflation. Furthermore, the structural reforms implemented from the second half of the 1980s helped to improve resource allocation and contributed to reducing inflation.11

Governing Structure

As the mandate of central banks changed over time, so did their governing structure. During their early years, central banks were run by a manager who executed policies approved by the board of directors, which typically included representatives of the government and private banks (Appendix 2.1). In some countries like Chile and Ecuador, business associations and labor organizations were also represented on the central bank board, while in Colombia one board member represented private citizens. In those central banks founded in the 1930s, the boards had a similar composition. The Board of the Central Bank of the Republic of Argentina had broad representation that included the executive branch, state-owned banks (national and provincial), private banks (domestic and foreign), and business associations. This wide representation was linked to the ownership of central banks, which in most cases included the government, the banking system, and the general public.

The shift in the mandate of central banks during the developmental phase was not accompanied by a change in their governing arrangement, except in a few countries. In most cases, the central bank’s board remained comprised of government and private sector representatives (Appendix 2.2). Argentina and, in particular, Colombia were exceptions. In Argentina, while the private sector remained on the board of the central bank, its representatives were appointed by the executive. A Monetary Board was set up in Colombia, chaired by the Minister of Finance and composed of the cabinet members in charge of economic issues, as well as the governor of the Bank of the Republic. Interestingly enough, the board membership did not mirror the ownership of central banks, which in some cases became exclusively government-owned. Central banks featured various combinations of board membership and ownership (Table 2.1). Preserving private sector representation on the central bank board—from commercial banks and business associations—was associated during the developmental phase with central banks’ policy of allocating credit across banks and economic activities. By the 1970s, all central banks in the region were already government owned.

Table 2.1Central Bank Ownership and Board Membership in the Developmental Phase, Selected Countries
Government OwnershipGovernment/Private

Ownership
Private Sector Ownership
Mostly government representationArgentina, Costa Rica, Dominican Republic, GuatemalaVenezuelaColombia
Government and private representationPeruChile, Ecuador, MexicoEl Salvador
Sources: Argentina: Law 25.120 (1949); Chile: Law 11151 (1953); Colombia: Decree 756 DE (1951), Law 21 (1963), and Decree 2206 DE (1963); Costa Rica: Law 1130 (1950); Dominican Republic: Law 1529 (1947); Ecuador: Law of the Monetary Regime (1948); El Salvador: Decree 64 (1952); Guatemala: Law 215 (1945); Mexico: Organic Law of the Bank of Mexico (1985); Peru: Organic Law 13958 (1962); Venezuela: Banco Central de Venezuela Law (1960).
Sources: Argentina: Law 25.120 (1949); Chile: Law 11151 (1953); Colombia: Decree 756 DE (1951), Law 21 (1963), and Decree 2206 DE (1963); Costa Rica: Law 1130 (1950); Dominican Republic: Law 1529 (1947); Ecuador: Law of the Monetary Regime (1948); El Salvador: Decree 64 (1952); Guatemala: Law 215 (1945); Mexico: Organic Law of the Bank of Mexico (1985); Peru: Organic Law 13958 (1962); Venezuela: Banco Central de Venezuela Law (1960).

The 1990s reform of central bank legislation in Latin America introduced a drastic change in their governing arrangements. In the vast majority of countries, central banks became governed by a board of directors that excluded government and private sector representatives (Appendix 2.3) and consisted instead of technocrats appointed for tenures ranging from 4 to 10 years—sometimes in a staggered fashion—and devoted full time to their job.12 Thus, central banks were empowered to formulate monetary policy with a long-term perspective that exceeded electoral calendars. Often, the new laws called for the central bank’s board of directors to not respond to the government. Moreover, in most cases, the reform established restrictions on the removal of the members of the board, except through procedures whereby the legislative or judicial branch approved dismissal on grounds strictly codified in law.

Independence

While central banks were not initially created as politically independent institutions, they enjoyed de facto operational independence. With a diversified membership of central bank boards, lawmakers tried to establish checks and balances by preventing any single party, public or private, from controlling central bank policy decisions. Moreover, while monetary policy was part of the government’s broad economic policy, the issuance of currency was restricted by the rules associated with the endorsement of the gold standard, as explained later in this chapter. In addition, government and commercial banks were subject to specific operational restrictions when receiving credit from the central bank in order to protect its balance sheet.13

This operational independence was undermined when countries abandoned the gold standard. Restrictions to issue money were increasingly relaxed, and central bank credit to the government started to increase in several countries. While it was initially necessary to expand central bank balance sheets to bring the Latin American economies back from the brink of collapse during the Great Depression, governments became addicted to central bank financing, thus undermining central banks’ independence.

During the developmental phase, central banks lost any vestige of independence. Since the new legislation modified the governing structure of some central banks, and because the banks’ policy goals had changed, representatives of the government and state-owned financial institutions populated central bank boards. Moreover, the executive branch became directly involved in monetary policy formulation and decisions.14 As a result, central banks extended credit through the banking system to priority sectors selected by the government and deepened the financing of government expenditure.

Governments’ control of central banks deepened in some countries following the demise of the Bretton Woods system in the early 1970s, and continued until the late 1980s. Fiscal dominance became stronger in the 1970s, in particular in the Southern Cone countries, where central banks were put at the service of populist governments. In Chile, financing the fiscal deficit reached 30 percent of GDP by 1973 (Corbo and Hernandez 2005), and in Argentina central bank credit to the government increased almost 130 percent in 1973—well above the inflation rate of about 60 percent in the same year.15 In the 1980s, “financial dominance” gained strength as governments decided to use central bank money on a large scale to cope with systemic financial crises.

In the 1990s, after more than 50 years of burdening Latin American central banks with multiple objectives, governments granted them political and operational independence to focus primarily—and sometimes exclusively—on containing inflation. Countries accepted that the main contribution of monetary policy to economic growth was to achieve and preserve low and stable inflation. In a region battered by decades of high inflation, a comprehensive monetary reform was necessary. Thus, all Latin American countries except Brazil approved new central bank laws—starting with Chile in 1989—throughout the 1990s and early 2000s.16 Central bank independence was the backbone of this reform, serving as a way to avoid the inflationary bias stemming from political influences on monetary policy.17

Although the scope of the new central bank legislation varied across countries, it had four common elements. First, central banks were assigned as a single or primary objective to preserve price stability.18 Second, they were granted political independence to formulate monetary policy with the aim of delinking monetary policymaking from electoral calendars; the new laws called for the central bank’s board of directors to be independent of the government (and the private sector) and established restrictions on the removal of its members. Third, central banks were granted operational independence to implement monetary policy, allowing them to increase or reduce their short-term interest rate to tighten or loosen monetary policy without government interference. The new legislation also restricted and even prohibited central banks from financing government expenditure—the chronic source of inflation. Fourth, central banks were held accountable with respect to their policy objective.19

The changes introduced by the new legislation implied a broad enhancement of central bank independence as measured by a modified Cukierman index of central bank independence (Figure 2.2, panel 1) (Cukierman, Webb, and Neyapti 1992).20 As a result, Latin American central banks rank today among the most independent worldwide.21 Unlike in advanced economies, central banks not only enjoy instrument independence (freedom to use monetary policy instruments without any political interference), but also goal independence (which allows them to set the inflation target without the need for government approval). Nonetheless, this trend has already been reversed in some countries like Argentina, Bolivia, and Venezuela, with the main objective of authorizing the central bank to finance the fiscal deficit. These countries either reformed central bank legislation or included relevant provisions in the yearly budget laws to bypass the restrictions included in the central bank laws. Panel 2 of Figure 2.2 offers a historical perspective of the reversal of central bank independence in Argentina.

Figure 2.2.Central Bank Independence in Latin America

Source: Jácome and Vázquez (2008) for Panel 1 and author’s calculations for panel 2.

Note: The index of central bank independence is measured on the x axis in panel 1 and the y axis in panel 2. The index of central bank independence in panel 1 is explained in Jácome and Vázquez (2008). The index used in panel 2 has been simplified to ensure comparability over such a long time period.

Policy Framework

The historical evolution of monetary policy in Latin America can be tracked through the lens of the trilemma hypothesis.22 This theory contends that small open economies can only simultaneously achieve two of the following three policy goals: (1) exchange rate stability; (2) financial integration with the rest of the world; and (3) monetary policy independence from global capital flows (Figure 2.3). In each of the three historical periods identified in this chapter, central banks in Latin America opted for different combinations of two of these three goals. The same analytical framework is also valid to discuss some of the constraints facing many central banks in the region in the aftermath of the global financial crisis.

Figure 2.3.Central Banking in Latin America and the Trilemma Triangle

Source: Prepared by the author.

Early Years

As countries in Latin America endorsed the gold standard in the 1920s (left corner in the triangle in Figure 2.3), central banks committed to preserve the convertibility of their currencies at a fixed exchange rate and keep the capital account open. This monetary system imposed an automatic adjustment mechanism for balance of payment disequilibria, making monetary policy endogenous. Central banks could only issue bank notes if they were backed with international reserves, mostly gold and foreign currency convertible into gold. Thus, when international reserves declined, money supply also contracted. Interest rates then increased, attracting capital inflows and thus restoring international reserves and the money supply, although at the cost of restricting aggregate demand.

The main monetary policy instrument used was the discount rate. However, this rate could vary across economic agents and activities—like the industrial and agricultural sectors that paid lower rates.23 The discount rate also varied depending on the amount of the loan and the likelihood of its recovery.24

Endorsing the gold standard in the midst of the Great Depression became an insurmountable restriction. Thus, Chile, Colombia, Ecuador, Mexico, and Peru suspended the convertibility of their currencies and, later on, officially exited the gold standard during 1931 and 1932. As a result, central banks were no longer restricted to issue money and extend credit, and could potentially adjust the exchange rate as needed. In practice, central banks preserved exchange rate stability as they introduced capital restrictions that, in addition, allowed them to gradually gain control over monetary policy (lower side of the triangle in Figure 2.3). In addition, central banks were potentially able to implement countercyclical policies.

As monetary policy became exogenous, countries started to enhance their policy toolkit. Changes in discount rates gradually lost popularity and, as an alternative, central banks began to use other instruments. Pioneered by Mexico, changes in reserve requirements started to gain popularity as a policy instrument.25 The central bank in Argentina issued Certificates of Participation and used Treasury Certificates in 1935 and 1936 for liquidity management purposes. During the early 1940s, several countries started to impose quantitative restrictions on central bank credit to avoid increasing the interest rates.

Central banks’ balance sheets expanded following the gold standard years, as financing to the government increased. In Chile, the surge in government financing was aimed at taming the economic contraction stemming from the Great Depression in the early 1930s, which was followed by the extension of credit lines to other public sector institutions. Later, in the early 1940s, the expansion was mostly driven by the increase in foreign exchange reserves. In Peru, credit to the government increased more than threefold between 1933 and 1938, and rose another 300 percent by 1944 (Figure 2.4). In Mexico, central bank credit to the government exceeded its loans to the banking system by more than five times and represented close to 45 percent of the Bank of Mexico’s total assets by 1940.26 Argentina was different, since the rise in international reserves was the main driver of the increase in the central bank’s balance sheet.27

Figure 2.4Central Bank Assets in Chile and Peru

Sources: Central Bank of Chile, Annual Reports; and Central Reserve Bank of Peru, Annual Reports.

Developmental Phase

Monetary policy during most of the developmental phase was conditioned by the restrictions imposed by the Bretton Woods system established in 1945. The new international monetary system required countries to maintain fixed, although adjustable, exchange rates and to commit to the convertibility of their currencies against the U.S. dollar, which was chosen as the new reserve asset—instead of gold like in the gold standard years. The Bretton Woods Agreement provided rules to restore exchange rate stability and avoid competitive devaluations. While countries were required to state a par value against the U.S. dollar—or against gold—and to maintain it fixed within a 1 percent range above and below such value, countries were also entitled to change the par value by up to 10 percent. Countries also expanded their array of capital controls, which allowed central banks to fully enjoy an independent monetary policy (right corner in the triangle in Figure 2.3).

Against this backdrop, monetary policy became broadly aligned with governments’ policies, albeit restricted by the rules of the Bretton Woods system. Central banks extended credit through the banking system to priority sectors selected by the government—typically to the agricultural and industrial sectors—with the aim of supporting its development strategy. Furthermore, central banks became the most important source of government financing, thus leading to increasing macroeconomic instability.

Because countries maintained a fixed exchange rate, expansionary monetary policy resulted in current account deficits that had to be financed with international reserves. The Bretton Woods system linked monetary imbalances with changes in international reserves, as the capital account was relatively closed. Thus, central banks’ credit to both the private sector and the government had to be kept in check to avoid a drain of international reserves. This policy framework was the so-called “monetary approach to the balance of payments” popularized by the International Monetary Fund, as it was embedded in the economic programs negotiated with its member countries to eliminate balance of payments disequilibrium.28

Under this policy framework, financing economic development proved to be inconsistent with maintaining a fixed parity. Lax monetary policies resulted in current account deficits, which drained international reserves and led to currency crises and a rise in inflation. Inflation also contributed to the increase in money supply in order to preserve real money balances, thus creating mutually reinforcing feedback. The close co-movements of inflation and money supply in Brazil and Chile during 1946–70 illustrate this point (Figure 2.5).

Figure 2.5.Money Growth and Inflation in Brazil and Chile, 1946–70

(Percentage rate year over year)

Sources: Brazil: Central Bank of Brazil and IGP-DI, FGV for inflation; Chile: Braun-Llona and others (2000).

Following the demise of the Bretton Woods system in the early 1970s, central banks could more freely adjust the exchange rate. Since the convertibility of the U.S. dollar into gold at a fixed value was no longer in effect, exchange rates in several countries were devalued frequently in response to the inflation associated with the loose monetary policies in place. In particular, in the Southern Cone countries, left-wing governments implemented expansionary fiscal and monetary policies that ended up fueling broad macroeconomic instability. As inflation soared, these countries turned to stabilization policies, implementing for the first time some sort of forward-looking monetary policy, the so-called “tablita” arrangements.29 Other countries, in turn, received fresh capital inflows, which mostly translated into dollar credits and thus led to increased dollarization of the economies and to sizable fiscal and external disequilibrium.30

By the early 1980s, capital inflows reversed in response to the surge in interest rates in advanced economies. Most Latin American countries had by that time accumulated large external obligations to finance fiscal and external imbalances. Capital outflows generated large devaluations, which hit the dollarized balance sheets of firms, banks, and the government, thus leading to a triple crisis—currency, banking, and sovereign—that pushed inflation through the roof. Central banks were at the center of the policy response to cope with financial crises, providing exceptional monetary support to assist ailing banks, restructure the financial system, and support borrowers.31 In turn, governments implemented income policy and price controls with a view toward tackling inflation inertia, considered the main factor driving inflation, as well as fiscal adjustment.32 However, fiscal tightening faltered in most cases and, therefore, the exchange rate plunged and inflation—which initially had declined—eventually rebounded at even higher levels.

Golden Years

Protracted macroeconomic instability took a high toll on the Latin American economies. The 1980s became the “lost decade” for the region. As economic and social costs associated with persistent high inflation became insurmountable, countries decided to grant central banks political autonomy and assigned them the task of defeating inflation. The autonomy granted to central banks implied giving them independence to formulate monetary policy and increase or reduce their short-term interest rate to tighten or loosen monetary policy as needed without government interference. A handful of countries also introduced exchange rate flexibility, and most of them completely opened the capital account (upper corner in the triangle in Figure 2.3). Other countries used the exchange rate to reduce inflation (Brazil, Chile, Colombia, Ecuador). Thus, by the mid-1990s, inflation started to decline.

However, a new wave of banking crises hit Latin America from the mid-1990s to the early 2000s, which fueled bouts of inflation in some countries. Foreign capital had returned to Latin America in the early 1990s following the restructuring of external debts and attracted by the financial liberalization recently introduced. Capital inflows appreciated real exchange rates and boosted banks’ credit, whereas financial and capital account liberalization encouraged new and often risky financial transactions. Yet, prudential standards did not keep the pace of financial innovations and the heightened risks incurred by banks, and thus financial vulnerabilities grew unchecked. The combination of financial and capital account liberalization and weak prudential regulation and supervision sowed the seeds of systemic banking crises that materialized starting in the mid-1990s in Venezuela and Mexico. In several crises, the lack of exchange rate flexibility played an amplifier role as central banks had to abandon the fixed or quasi-fixed parity. This turned into foreign exchange overshooting that hit back at the banking system (Jácome 2008). In the absence of appropriate crisis management instruments in most countries, central banks were once again required to monetize the crises, which inevitably led to simultaneous currency and, in some cases, sovereign, crises. As a result, inflation accelerated once again (Jácome, Saadi-Sedik, and Townsend 2012).

As financial crises subsided and inflation declined again, several countries in the region introduced inflation targeting as their new monetary policy regime. Brazil, Chile, Colombia, Mexico, and Peru (the LA5) pioneered the adoption of inflation targeting in Latin America in the late 1990s and early 2000s, but other countries have followed.33 The credibility of the LA5 inflation-targeting regimes increased over time as central banks fulfilled their promise, and inflation generally remained within the target range.34 Compared to other emerging market inflation targeters, most LA5 central banks performed well, as the deviations of inflation with respect to the target were smaller (Figure 2.6).35 Building up credibility had a reinforcing effect on the effectiveness of monetary policy, as market participants tend to align inflation expectations with central bank targets, thereby creating a virtuous circle. A key factor in this success has been a policy of clear central bank communication. Reversing a history of secrecy, central banks in Latin America increasingly started to disseminate information to the public. In particular, central banks issued press releases following their policy meetings—in which the central bank board decided about the policy rate—with the aim of explaining decisions and guiding inflation expectations in order to enhance the effectiveness of monetary policy.

Figure 2.6.Inflation Deviation from Target in Inflation-Targeting Emerging Market Economies

(Percentage points, absolute value)

Sources: Central banks; Haver Analytics; and author’s calculations.

Note: Average absolute value deviation of inflation from target since the adoption of inflation targeting until 2015:Q2. Most countries target the Consumer Price Index (CPI), with the exception of Thailand (Core CPI), Korea (Core CPI in 2000–06), and South Africa (CPIX until end-2008).

Operationally, central banks moved to an intensive use of a short-term interest rate as their key monetary policy instrument, leaving behind the frequent use of reserve requirements and quantity-targeted open-market operations. Changes in the policy rate were aimed at affecting the real sector of the economy—output and inflation—and at signaling the stance of monetary policy in order to guide inflation expectations. The policy rate transmitted monetary impulses to the real sector via the financial system. Behind the scenes, central banks started to manage systemic liquidity and use open-market operations to keep the short-term interbank rate close to the policy rate. Central banks also introduced standing deposit and Lombard facilities, below and above the policy rate, to offer overnight liquidity absorption and provision.

The global financial crisis of 2008 tested the preparedness of Latin American central banks to manage large real and financial shocks. Based on macro-financial fundamentals that were stronger than in the past and on buffer mechanisms put in place over several years, the Latin American economies, and specifically the LA5, successfully handled large real and financial shocks stemming from the global financial crisis. Supported by their solid institutional underpinnings, central banks weathered the reversal of capital inflows well and contributed decisively to stem subsequent deflationary pressures. The credibility already gained by central banks was critical for this achievement. The relatively modest impact of the financial crisis on the LA5 countries constituted a stark contrast to previous crisis episodes.

As the advanced economies lowered policy rates to the zero lower bound, capitals migrated once again to the financially integrated Latin American countries. To prevent excessive exchange rate appreciation and/or the buildup of financial vulnerabilities, the central banks in Brazil, Colombia, and Peru stepped up intervention in the foreign exchange market, and introduced or tightened capital flow management measures and/or macroprudential policies to discourage speculative capital inflows.36 By using these measures and tools, the Latin American countries departed from the trilemma hypothesis (moved to the center of the triangle in Figure 2.3). While useful, maintaining a flexible exchange rate proved to be insufficient to keep full control over monetary policy while, at the same time, avoiding large exchange rate volatility and preventing financial vulnerabilities—that could eventually challenge the objective of price stability—in response to the effects of the global cycle and the associated shifts in capital flows.37

The Long Road to Price Stability

Against a backdrop of an evolving institutional and policy framework, inflation has been high and volatile during the lifespans of most of Latin America’s central banks. However, there are clear differences in central bank performance for each of the three periods analyzed in this chapter, as illustrated by a snapshot of the evolution of inflation in Brazil, Chile, Colombia, and Peru during the last 100 years (Figure 2.7).

Figure 2.7Brazil, Chile, Colombia, and Peru: 100 Years of Inflation

(1 + inflation, logs, year over year)

Sources: Peru: Central Reserve Bank of Peru; Chile: Diaz, Lüders, and Wagner (2010); Colombia: Grupo de Estudios de Crecimiento Económico (2001); Brazil: 1901–08: Suzigan and Villela (2001); 1909–47: Haddad (1978); 1948–2013: Instituto Brasileiro de Geografia e Estatística.

Note: Chile, Colombia, and Peru: annual inflation rate. Brazil: annual implicit deflator; from 1981 onward, Consumer Price Index.

Before and immediately after the creation of the central banks, inflation was low but volatile—with prices even declining significantly in several years. Monetary policy was endogenous due to the restrictions imposed by the rules of the gold standard, and thus inflation and output were determined by external shocks and the international economic cycle. The procyclical nature of the adjustment mechanism associated with the gold standard also influenced inflation and output performance.

As countries abandoned the gold standard, central banks acquired discretion to implement monetary policy. Monetary expansion accelerated mostly to finance the government, thus sowing the seeds of higher inflation. During the developmental phase, with a mandate to finance economic growth and development, central bank credit was used and abused, especially to finance government expenditure. The interventionist monetary policy took its toll on macroeconomic stability. Inflation in Latin America accelerated markedly from the 1950s onward, in particular in the Southern Cone countries (Argentina, Chile, and Uruguay) and Brazil. Eventually, a number of countries in the region entered into a spiral of monetary expansion-devaluation-monetary expansion that fueled increasing inflation until soaring prices got out of control. By the late 1980s and early 1990s inflation had reached four-digit rates in countries such as Argentina, Brazil, Nicaragua, and Peru.

With a new central bank mandate focused on a single objective, namely price stability, inflation started to decline by the mid-1990s. By 2000, annual inflation in Latin America had declined from about 500 percent in 1990 to below 10 percent.38 But it was only in the mid-2000s that most countries in Latin America finally conquered inflation. In a region with a history of endemic inflation, this was a major achievement. Price stability was also possible because these countries simultaneously introduced, and maintained over time, sound macroeconomic policies—in particular fiscal policies—and strengthened their financial systems, and because they benefited from declining inflation globally.

After having defeated inflation and later successfully weathered the effects of the global financial crisis, central banks in Latin America may have entered into a new transition phase. They have started to move toward taking greater responsibility for securing the stability of financial systems. Central banks in Latin America may also be called upon to help stem the deceleration of economic growth or to restore its momentum.

Central banks in the region already had responsibilities in the past for helping to preserve financial stability—other than being the lender of last resort. In particular, those central banks created under the “Atlantic model” (Argentina, Brazil, Paraguay, and Uruguay), have a mandate of financial stability and thus regulate and supervise banks, and have implicit crisis management responsibilities. In general, most central banks rediscounted paper to financial institutions over the course of the 1920s to the 1990s, verifying that those institutions were on a sound financial footing. In this sense, central banks used to help keep financial stability in check and to fund financial institutions, thus minimizing the possibility of liquidity shortages. However, this practice was abandoned during the 1990s—following the latest central bank reform—to allow financial institutions to effectively play the role of financial intermediaries and central banks to focus on fighting inflation.

Today, assigning Latin American central banks financial stability responsibilities would have different implications. On the one hand, it would provide central banks with the institutional underpinnings to “lean against the wind” to moderate macroeconomic fluctuations caused by financial factors. On the other hand, central banks might be called on to develop a macroprudential policy function and thus become responsible for monitoring the buildup of systemic financial vulnerabilities and for taking decisions to prevent systemic crises—involving not only banks but also other financial intermediaries. Some Latin American countries (Chile, Mexico, and Uruguay) have already established financial stability committees, although the mandate of central banks has not been modified.39

The case for making central banks in Latin America responsible for economic growth and/or employment is less clear cut. In the aftermath of the recent crisis, central banks in major advanced economies have provided monetary accommodation to mitigate the recession and later to make the recovery less protracted. Central banks in Latin America had already implemented similar policies in the wake of the Great Depression, but the results became negative in the long term when their use was prolonged for normal times. Some LA5 central banks turned to this policy option during the Great Recession, but only as a last resort and in modest amounts. Operationally, should central banks in Latin America expand their monetary policy toolkit to incorporate unconventional policies as a way of boosting growth and employment?40 In Latin America—like in other developing and emerging market economies—monetary policy is not likely to be effective in spurring growth and/or employment in the long term. Economic activity is highly dependent on external conductors in the short term, and hinges to a great extent on structural changes to feed employment and enhance productivity in the long term.

Meanwhile, some central banks in Latin America face challenges from the global economy. Specifically, it is unclear to what extent the financially integrated economies in Latin America can preserve monetary policy independence in a world of unsynchronized economic cycles. Monetary policy decisions in the region seems to be sensitive to decisions taken—and even to those only announced—by the U.S. Federal Reserve. These decisions and announcements can fuel capital flow reversals, and hence, exchange rate depreciations and inflation, thus generating pressure to elevate interest rates independently of domestic considerations. growing stream of literature, including Chapters 4 and 5 in this book, empirically analyzes the effect of monetary policy actions in advanced economies on central bank decisions in emerging markets.41 Furthermore, in those countries in the region for which China is the main trading partner (Argentina, Brazil, Colombia, and Peru, among others) central banks face the dilemma of whether to increase the policy rate, as such an increase exacerbates the adverse impact of China’s economic deceleration on Latin American exports and thus output.

Conclusions

It took about 80 years for Latin American central banks to achieve low and stable inflation. It was a long and rocky journey during which central banks were assigned different mandates and governments influenced monetary policy for about 50 years. As a result, many countries went through long periods of high inflation. However, following the institutional reform of monetary policy in the 1990s and the subsequent introduction of a forward-looking monetary policy focused on fighting inflation as a primary policy objective, a number of central banks finally achieved price stability. Latin American central banks later contributed decisively to helping the region successfully weather the global financial crisis.

The consequences of the global financial crisis and the Great Recession may trigger a new era of central banking in Latin America, as is already happening in advanced economies. The severity of the crisis upset a number of economic verities, including the consensus that central banks should primarily focus on controlling inflation. In response, a new paradigm has emerged, one that assigns central banks an enhanced role in preserving systemic financial stability. Central banks have also been called upon to help foster economic activity through the expansion of their balance sheets. The financial reform has just started to take hold in some Latin American countries. Learning from history might be useful in providing additional perspective as to how to shape future central bank policies in this region. The challenge is to avoid a situation where a new institutional and policy framework undermines central bank autonomy and accountability and, therefore, central banks’ hard-won credibility.

Appendix 2.1. Main Responsibilities and Governance of Central Banks in Latin America When They Were Founded
CountryMain ResponsibilitiesComposition of BoardOwnership
Argentina (1935)- Issue the domestic currency.

- Regulate the amount of money and credit in line with the needs of the economy.

- Accumulate sufficient international reserves to moderate the adverse effects of exports and foreign investments and preserve the value of the currency.

- Preserve appropriate conditions of liquidity and credit and apply the legislation to the banking system.

- Act as fiscal agent and advisor to the government for the management of debt.
President and Vice President appointed by the President of the Republic and confirmed by the Senate; one member appointed by the executive branch; one by the Banco Nación; one by the provincial banks; three by the private banks; two by the foreign banks; and four representing the business associations.Government and the banking system.
Chile (1925)- Issue the national currency.

- Conduct rediscount and discount operations with banks and the general public.

- Provide financial assistance to the public sector on a limited basis.

- Work as a fiscal agent.

- Receive deposits from banks, the public sector, and the general public.

- Provide clearing for payments.

- Define the rediscount rate.
The President of the Republic appointed three board members; the banks appointed three; the business associations, two; the general public shareholders, one; and labor organizations, one.Government, the banking system, and the general public.
Colombia (1922)- Issue the national currency.

- Conduct rediscount and discount operations with banks and the general public.

- Provide financial assistance to the public sector on a limited basis.

- Work as a fiscal agent.

- Receive deposits from banks, the public sector, and the general public.

- Provide clearing for payments.

- Define the rediscount rate.
The President of the Republic appointed three board members; the domestic and international banks appointed four and two members, respectively; and the general public had one representative.Government, the banking system, and the general public.
Ecuador (1927)- Issue the national currency.

- Act as lender of last resort to the banking system.

- Conduct rediscount and discount operations with banks and the general public.

- Provide financial assistance to the public sector on a limited basis.

- Work as a fiscal agent.

- Receive deposits from banks, the public sector, and the general public.

- Define the rediscount rate.

- Provide clearing for payments.
The President of the Republic appointed two members, commercial banks two members, business associations three members, and labor organizations one member.The private banks, the general public, and the government (without voting rights).
El Salvador (1934)- Issue the domestic currency.

- Control the volume of credit and the money supply.

- Preserve the external value of the currency.

- Act as a fiscal agent and receive deposits from the government.
Five members designated by the central bank’s shareholders.Commercial banks and the Coffee Producers Association.
Mexico (1925)- Issue currency.

- Regulate the circulation of money, the exchange rate, and the interest rate.

- Rediscount operations to banks.

- Provide support to the government for Treasury operations

- Perform similar operations as the banking system.
The President of the Republic appointed five members and the shareholders appointed another four members.Government and the general public.
Peru (1922)- Monopoly of currency issue.

- Receive deposits from banks, the public sector, and the general public.

- Discount and rediscount commercial paper, treasury bonds, and other financial instruments.

- Define discount rates.

- Provide clearing for payments.

- Provide financing to the government on a limited basis.
The President of the Republic appointed three members, the local banks four members, and the foreign banks three members.National and international banks.
Sources: Argentina: Law 12.155 (1935); Chile: Law 486 (1925); Colombia: Sanchez, Fernández, and Armenta (2005) and Bank of the Republic website; Ecuador: Organic Law of the Central Bank of Ecuador (1927); El Salvador: Central Reserve Bank of El Salvador website; Mexico: Law that created the Bank of Mexico (1925); Peru: Law 4500 (1922).
Sources: Argentina: Law 12.155 (1935); Chile: Law 486 (1925); Colombia: Sanchez, Fernández, and Armenta (2005) and Bank of the Republic website; Ecuador: Organic Law of the Central Bank of Ecuador (1927); El Salvador: Central Reserve Bank of El Salvador website; Mexico: Law that created the Bank of Mexico (1925); Peru: Law 4500 (1922).
Appendix 2.2. Main Responsibilities and Governance of Central Banks in Latin America During the Developmental Phase
CountryMain Objectives/ResponsibilitiesComposition of BoardOwnership
Argentina (1949)Responsibilities:

- Handle international reserves and execute capital controls to smooth out the impact from changes in trade and capital transactions on the currency and economic activity.

- Regulate the amount of money and credit in order to secure conditions to preserve a high level of employment and the purchasing power of the currency.

- Monitor liquidity and the appropriate flow of credit and implement the Banking Law.

- Preserve and regulate developments in the securities market and act as fiscal agent for internal and external debt transactions.
The Minister and Vice Minister of Finance are President and Vice President of the Board; the presidents of the four following banks: Nación Argentina, Crédito Industrial Argentino, Hipotecario Nacional, and Caja Nacional de Ahorro Postal; five members appointed by the President of the Republic and who represent the agriculture, livestock, industrial, and trade sectors, as well as workers.Government.
Chile (1953)Objective:

Orderly and continuous development of the national economy, implement monetary and credit policies to avoid inflationary and deflationary trends, and facilitate the best use of the country’s productive resources.
The President of the Republic appointed three board members; banks appointed three; business associations, two; general public shareholders, one; and labor organizations, one.Government, the banking system, and the general public.
Colombia (1951 for the objective and 1963 for the Monetary Board)Objective:

Conduct monetary, credit, and exchange rate policies with the aim of fostering the appropriate conditions for an orderly development of the Colombian economy.

Responsibilities:

- Issue the national currency.

- Conduct rediscount and discount operations with banks and the general public.

- Provide financial assistance to the public sector on a limited basis.

- Work as a fiscal agent.

- Receive deposits from banks, the public sector, and the general public.

- Provide clearing for payments.

- Define the rediscount rate.
Monetary Board comprised of the Minister of Finance; Minister of Economy; Minister of Agriculture; Head of the Planning Office; and the General Manager of the Bank of the Republic.The banking system and the general public.
Ecuador (1948)Responsibilities:

- Adapt the money supply and the flow of credit to the needs of the country.

- Prevent and moderate inflationary and deflationary trends.

- Promote the effective functioning of the banking system and the appropriate distribution of credit.

- Coordinate with economic and fiscal activities that may affect credit and money markets.

- Preserve the external value of the currency and its convertibility.

- Preserve the competitiveness of the national production in international markets.

-Prevent or moderate the adverse effects on the money supply and inflation from cyclical disequilibrium of the balance of payments.
Monetary Board comprised of one member appointed by Congress; the Minister of Finance; a representative of the National Economic Council; a representative of the Institute of Social Security; one member each appointed by commercial banks from the Coastal and from Andean regions; one member each appointed by business associations from the Coastal and Andean region; and one member appointed by the other members of the Monetary Board.Government and the private banks.
Guatemala (1945)Objective:

Promote and maintain monetary, exchange rate, and credit conditions most favorable to the orderly development of the economy.

Responsibilities:

- Adapt the means of payment and credit policy to the needs of the country and the development of productive activities, preventing inflationary and deflationary trends.

- Promote liquidity and solvency of the banking system and distribute credit according to the economic needs of the country.

- Coordinate between monetary and fiscal policies as well as with other economic and financial policies.

- Preserve the external value of the currency and its convertibility.

- Administer international reserves.

- Safeguard the international competitiveness of the domestic production.
Monetary Board comprised of the President and Vice President appointed by the President of the Republic; Ministers of Finance, Economy, and Agriculture; one representative from San Carlos University; one from the private banks; one from state-owned banks; and one from business associations (agriculture, industry, and trade).Government.
Mexico (1941 and reforms)Objective:

Issue currency and preserve credit and foreign exchange conditions that favor the stability of the purchasing power of money, financial system development, and sound economic growth.

Responsibilities:

- Regulate currency issue and circulation, as well as credit and the exchange rate.

- Lender of last resort and operate the payments system.

- Financial agent of the government for domestic and external credit operations, and provide treasury services to the government.

- Advise the government on economic and financial issues.

- Represent the country at the IMF and other multilateral institutions related to central banks in line with national objectives and planning, under the guidelines for monetary and credit policies defined by the Secretary of Treasury.
Governing Board comprised of 11 members: the Secretary and Under Secretary of the Treasury; the Secretary of the Budget; the Secretary of Trade and Industry; the Director General of the Bank of Mexico; the presidents of the Banking and Insurance Commission and of the Securities Commission; the president of the Banking Association; and three external members appointed by the executive branch.Government.
Peru (1962)Objective:

Preserve monetary stability, credit, and exchange rate conditions conducive to orderly development of the economy, with the support of adequate fiscal and economic policies.

Functions:

- Currency issue and monetary regulation.

- Regulate banks’ credit.

- Administer the country’s international reserves.
The President of the Republic appointed three members and the other six members representing development banks, regional commercial banks, commercial banks established in Lima, the agriculture sector, the industrial sector, and trade associations.Government.
Sources: Argentina: Law 25.120 (1949); Chile: Law 11151 (1953); Colombia: Decree 756 DE (1951), Law 21 (1963), and Decree 2206 DE (1963); Ecuador: Law of the Monetary Regime (1948); Guatemala: Law 215 (1945); Mexico: Organic Law of the Bank of Mexico (1985); Peru: Organic Law 13958 (1962).
Sources: Argentina: Law 25.120 (1949); Chile: Law 11151 (1953); Colombia: Decree 756 DE (1951), Law 21 (1963), and Decree 2206 DE (1963); Ecuador: Law of the Monetary Regime (1948); Guatemala: Law 215 (1945); Mexico: Organic Law of the Bank of Mexico (1985); Peru: Organic Law 13958 (1962).
Appendix 2.3. Policy Objectives and Governance of Central Banks in Latin America During the Golden Age
CountryObjectivesComposition of BoardTerm in Office
Chile (1989)Stability of the currency and functioning of domestic and external payments.Five directors appointed by the executive and confirmed by the Senate for staggered terms.Term for central bank president is five years, and for the other directors it is 10 years.
Colombia (1992)Preserve price stability.Minister of Finance (Chair), General Manager of central bank (appointed by the board), and five directors appointed for staggered terms by the executive branch.The six directors, including the general manager of the central bank, serve for four years with a renewable term.
Costa Rica (1995)Maintain the domestic and external stability of the currency.President of the central bank and five members, appointed by the executive, plus the Minister of Finance. Five members appointed for staggered terms and confirmed by Congress.President of the central bank has a four-year term, like the President of the Republic. The other five members’ terms are 90 months.
Honduras (1996)Maintain internal and external value of domestic currency and favor normal functioning of the payment system.Executive appoints five directors. Minister of Finance is part of the board without decision power.Four years simultaneously with government period.
Mexico (1993)Ensure the stability of the currency’s purchasing power; the central bank should also promote the sound development of the financial system and the functioning of the payments system.Five members appointed by the President of the Republic with the approval of the Senate.Governor’s term is six years and for other members it is eight years, with staggered appointments.
Peru (1993)Preserve monetary stability.Executive nominates four directors, including the central bank president. Congress ratifies this decision and appoints three additional directors.The same as the President of the Republic.
Uruguay (1995)Ensure currency stability, functioning of domestic and external payments, and adequate levels of international reserves, and promote and maintain soundness, solvency, and operations of the financial system.The executive, with the approval of the Senate, appoints the president, vice president, and a director of the central bank.Appointed for the term of office of the President of the Republic.
Venezuela (1992)Create and maintain monetary, credit, and exchange rate conditions favorable to monetary stability, economic equilibrium, and orderly economic development.Executive nominates the central bank president (confirmed by Senate) and six directors, including a member from the executive (not the Minister of Finance).The president is appointed for five years and the directors for six years staggered, except for the executive member.
Sources: Chile: Law 18840; Colombia: Law 31/1992; Costa Rica: Law 7558; Honduras: Decree 228-96; Mexico: Law of the Bank of Mexico (1993); Peru: Law 26123; Uruguay: Law 16.696; Venezuela B.R.: Law 31.
Sources: Chile: Law 18840; Colombia: Law 31/1992; Costa Rica: Law 7558; Honduras: Decree 228-96; Mexico: Law of the Bank of Mexico (1993); Peru: Law 26123; Uruguay: Law 16.696; Venezuela B.R.: Law 31.
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Previous versions of this chapter benefited from comments by Ana Corbacho, Nicolás Magud, Miguel Savastano, Krishna Srinivasan, and seminar participants at the 2015 Meetings of the Latin American and Caribbean Economics Association.

The crisis ignited a debate about a new role of monetary policy beyond its primary responsibility of preserving price stability. The general perception is that in the run-up to the crisis, financial vulnerabilities grew unchecked. Central banks were blamed for failing to act to prevent the crisis, which was attributed to their narrow mandate that assigned them limited duties for preserving systemic financial stability. In the aftermath of the financial crisis, there was a sense of dissatisfaction with the tepid recovery that still prevails in many advanced economies. One of the alternatives considered has been to expand the focus of monetary policy to include growth.

The term “gold standard” is used throughout this chapter, but it was really the “gold exchange standard” that most Latin American countries actually endorsed. The latter allowed countries to convert domestic bank notes into bills of exchange denominated in a foreign currency that was convertible into gold at a fixed exchange rate.

Countries defined their exchange rate based on the rules associated with the gold standard. Given that the value of each currency was measured in terms of the amount of fine gold it contained, and because such value tended to differ across countries, it was possible to establish bilateral exchange rates. For example, because the sucre in Ecuador contained 0.300933 grams of fine gold in 1927 and the U.S. dollar contained 1.504665 grams, the exchange rate was 5 sucres per U.S. dollar (Carbo 1978). Similarly, since the Chilean peso contained 0.183057 grams of fine gold, the exchange rate was about 8 pesos per U.S. dollar (Carrasco 2009).

Central banks could also discount paper to the general public (Chile, Colombia, Ecuador, Mexico, and Peru until 1932) although, in practice, these transactions were small.

As before, the creation of these central banks was influenced by external experts. Sir Otto Niemeyer and Frederick Powell from the Bank of England visited Argentina and El Salvador, respectively, and Hermann Max from the Central Bank of Chile advised Venezuela.

Until then, state-owned banks—the Banco do Brasil and Banco Republica Oriental del Uruguay—conducted both commercial bank and central bank responsibilities.

In some cases, the new legislation was necessary because the term for the existence of the central bank set in the initial laws had expired. Argentina, Bolivia, Ecuador, and Guatemala changed central bank legislation in the mid- to late 1940s, whereas Chile and Colombia made those changes in the 1950s. In turn, El Salvador, Peru, and Venezuela changed their central bank law in the 1960s.

The Triffin missions were followed later by the Grove mission, also from the U.S. Federal Reserve, which provided similar recommendations to reform the Bank of the Republic of Colombia.

Dornbusch and Edwards (1990) defined economic populism as those policies that emphasize growth and income distribution and deemphasize inflation and deficit finance, external constraints, and the reaction of economic agents to aggressive nonmarket policies.

See Central Bank of Argentina, Annual Report, 1973.

See Lora (2001) for an analysis of the achievements of Latin America’s structural reforms and Jácome and Vázquez (2008) for empirical evidence on the positive impact of structural reforms on reducing inflation.

Board members started to be appointed in a two-step process, nominated by the executive branch and appointed by the parliament.

For instance, in Chile, central bank loans to the government—including local governments and public institutions—could not exceed 20 percent of its capital, although this limit could increase to 30 percent if approved by 8 of the 10 members of the central bank board (Carrasco 2009). In Colombia, this limit was initially 30 percent of central bank capital and increased to 45 percent in 1930 (Bank of the Republic website). On the other hand, the amount of rediscounts could not exceed 10 percent of the central bank’s capital in Mexico.

For instance, in Argentina, the National Economic Council was assigned a direct role from 1947 onward in formulating credit regulations, leaving to the central bank the operational responsibility to implement those decisions. Moreover, the 1949 reform to the central bank law made the Minister of Finance the president of the board of the central bank. Similarly, in Chile, starting in 1953, changes in reserve requirements were approved by the Minister of Finance and, in some cases, by the President of the Republic.

See Central Bank of Argentina, Annual Report, 1973.

El Salvador approved new central bank legislation in 1991; Argentina, Colombia, Ecuador, Nicaragua, and Venezuela in 1992; Peru and Mexico in 1993; Bolivia, Costa Rica, Uruguay, and Paraguay in 1995; Honduras in 1996; and Guatemala and the Dominican Republic in 2002.

The pioneering papers of Kydland and Prescott (1977), Barro and Gordon (1983), and Rogoff (1985) provided the theoretical basis for central bank independence.

To minimize the chances that a future change in the law would dilute the focus on price stability, countries like Chile, Colombia, Mexico, and Peru enshrined the new mandate in the constitutions.

For a comprehensive analysis of central bank reform in Latin America, see Carstens and Jácome (2005).

See an explanation of the index used in the calculations in Jácome and Vazquez (2008).

This analytical framework, also known as the “impossible trinity,” was pioneered by Fleming (1962) and Mundell (1963).

In Chile, for example, the central bank charged 1 percent less for commercial banks than for the general public. See Central Bank of Chile, Annual Report (1935).

For instance, starting in1926, the Bank of Mexico charged multiple rates in operations with the general public, ranging from 8 to 12 percent. See Bank of Mexico, Informe a la Asamblea General Ordinaria de Accionistas, 1926.

The Bank of Mexico changed the reserve requirement rate within the range of 3 and 15 percent from 1936 onward, and by between 15 and 20 percent from 1941 onward. Argentina also changed reserve requirements in 1936, as well as Venezuela in 1940, Nicaragua in 1941, and Costa Rica in 1943, among other countries.

The Bank of Mexico initially set restrictions on lending to the government at 10 percent of its capital. This restriction was relaxed in 1937 (Bank of Mexico, Informe de la Asamblea General Ordinaria de Accionistas, 1937 and 1940).

Article 44 of the Law No. 12.155 authorized credit operations to the government of up to 10 percent of the previous fiscal year’s revenues, with the aim of smoothing out the stream of such revenues. In turn, credit to financial institutions was provided by Banco Nación—a state-owned institution.

The approach was formalized by Polak (1957) and extended by Frenkel and Johnson (1976).

The new policy regime was aimed at breaking inflation inertia by using the exchange rate to anchor inflation expectations. It consisted in pre-announcing a crawling peg, specifying a daily decreasing pace of devaluation. Despite some initial success, the tablita program was ultimately not sustainable. Neither inflation nor interest rates declined at the same pace as the pre-announced rate of devaluation. As a result, the domestic currency became increasingly appreciated and, ultimately, large depreciations took place. For a comprehensive analysis of the tablita experiments see Corbo (1985) on Chile and Fernandez (1985) on Argentina.

International liquidity had increased as the so-called “petro-dollars” were recycled from the oil-exporting countries that had benefited from the surge in world oil prices.

See an expanded description of these measures in Jácome (2015).

For a description and analysis of the so-called “heterodox” economic programs, see Bruno and others (1988) and Bruno and others (1991).

These countries include Guatemala and, more recently, Costa Rica, the Dominican Republic, and Paraguay.

While the Central Bank of Brazil does not enjoy de jure independence, in practice, governments have most of time refrained from influencing monetary policy decisions.

A similar result is obtained when deviations are calculated with respect to the target range.

Brazil used a wide range of policy measures, such as increases in the tax rate on financial operations for some foreign exchange transactions, higher reserve requirements, higher risk weights for some sector loans, and lower loan-to-value ratios in the housing market. Colombia and Peru mostly tightened reserve requirements.

Rey (2015) suggests that the trilemma has been replaced by a dilemma, as monetary policy remains independent only if countries directly or indirectly manage the capital account, regardless of the exchange rate regime that is in place.

See the IMF’s World Economic Outlook (various issues).

In all cases, the minister of finance chairs this committee, which aims at overseeing financial systems as a whole and at preventing financial crises. Jácome, Nier, and Imam (2012) describe the structure of these committees and their responsibilities.

The advanced economies have already started to discuss whether to prolong accommodation and preserve unconventional instruments as part of the monetary policy toolkit, given that the Phillips curve no longer seems relevant in those economies (IMF 2013).

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