Abstract

Recently, the authorities of the Dominican Republic have permitted more exchange rate flexibility while attempting to increase gross official reserves. Under a managed float, as in the Dominican Republic, it is inappropriate when assessing the stance of monetary policy to examine either of these variables (exchange rate and reserve changes) in isolation. Instead, exchange rate and reserve movements should be combined to form a measure of exchange market pressure (EMP), which is defined as the sum of exchange rate depreciation and outflows of official international reserves.

Recently, the authorities of the Dominican Republic have permitted more exchange rate flexibility while attempting to increase gross official reserves. Under a managed float, as in the Dominican Republic, it is inappropriate when assessing the stance of monetary policy to examine either of these variables (exchange rate and reserve changes) in isolation. Instead, exchange rate and reserve movements should be combined to form a measure of exchange market pressure (EMP), which is defined as the sum of exchange rate depreciation and outflows of official international reserves.

Under a managed float, contractionary monetary policy should, all else being equal, attract capital inflows (raising official reserves) and increase the value of the Dominican peso, thereby reducing EMP. However, over time, lower EMP should increase investor confidence and ultimately reduce the differential between domestic and foreign interest rates.

This chapter examines several questions related to monetary policy and EMP in the Dominican Republic, First, according to the historical record, does monetary policy affect EMP in the way that standard monetary frameworks would predict? For example, has contractionary monetary policy been successful in either defending the peso or increasing international reserves? Second, and closely related, how should the stance of monetary policy be measured? While most recent work uses an interest rate as the policy variable, this chapter emphasizes changes in the domestic credit component of the monetary base, as in the traditional monetary approach to the balance of payments. Third is the interest rate differential itself a function of EMP? Does lower EMP boost investor confidence and thus reduce the interest rate differential? Fourth, is the stance of monetary policy itself a function of EMP? Do the monetary authorities respond to changes in EMP with monetary expansions or contractions? Do the monetary authorities systematically sterilize changes of EMP with changes in domestic credit, as in several other emerging markets? 95

To address such questions, this chapter develops a VAR framework with three variables, namely EMP, domestic credit growth, and the interest rate differential.96 This methodology is well suited to address the above questions since it pinpoints “shocks” or “innovations” to the variables mentioned above, estimates the responses to shocks between these variables, both contemporaneously and on a lagged basis, and summarizes how monetary policy (as measured by domestic credit growth) responds to lagged changes in either EMP or the interest differential.

Several policy-re levant conclusions (with numerical estimates) will be presented. First, the growth of central bank credit (scaled by base money) is a good indicator of the stance of monetary policy in the Dominican Republic. Second, monetary policy affects EMP significantly and in the direction predicted by theory. For example, a tightening of monetary policy, that is a reduction in central bank credit growth, reduces EMP, both immediately and, to a lesser degree, within a one- to five-month period. Third, domestic monetary policy had an ambiguous effect on the interest differential. Contractionary (expansionary) monetary policy is generally associated with interest rate increases (decreases). However, an effect in the opposite direction can also occur, since monetary expansions (contractions) can raise (lower) inflation expectations and cause interest rates to rise (fall). Moreover, reductions in EMP were associated with a lagged reduction in the interest rate differential, possibly reflecting increased investor confidence.

Exchange Market Pressure in the Dominican Republic: An Overview

Prior to 1991, the Dominican Republic fixed the official exchange rate,97 but devalued periodically. In late 1991, the authorities abandoned the fixed peg in favor of smaller, more frequent exchange rate movements. While the exchange rate has never floated freely, it has become more flexible in recent years. Between January 1992 and August 1994 monthly exchange rate depreciation averaged 0.15 percent. Subsequently, average monthly exchange rate depreciation was 0.35 percent, mainly reflecting devaluations in 1997 and 1998.

Under such a managed exchange rate regime, EMP is reflected in both exchange rate and reserve movements. Girton and Roper (1977) showed that EMP is the flow excess supply of money. To see this, consider the following simple monetary model. On the demand side, the growth of real base money (mt) is:

mt=ΔMt/Mt1πt(1)

where Mt is nominal (base) money at time t and πt is the inflation rate (ΔPt/Pt−1, where Pt is the price level at time t). The inflation rate is linked to foreign inflation πt* through the rate of growth of the nominal exchange rate et:

et=πtπt*+zt(2)

where zt is the deviation from purchasing power parity.

On the supply side, the two components of nominal base money are international reserves Rt and net domestic assets Dt. Thus,

ΔMt/Mt1=(ΔRt+ΔDt)/Mt1=rt+δt(3)

where rt = ΔRt/Mt−1 and δt = ΔDt/Mt−1. The above equations restate the traditional monetary approach. Assuming that purchasing power parity holds and foreign inflation equals zero (zt=πt*=0), substitute (2) and (3) into (1) and rearrange to obtain an expression for EMP:

etrt=δtmt(4)

According to equation (4), exchange rate depreciation plus reserve outflows (scaled by base money) equals the difference between the growth rates of the domestic component of the monetary base (δt) and money demand (mt).98 Under a fixed exchange rate regime, et=0; with freely floating exchange rates, rt=0.99

Table 34 and Table 13 present data on EMP, exchange rate growth, gross international reserves, and the interest rate differential in the Dominican Republic for the period 1992–98 and selected subperi-ods.100 These data show that EMP in the Dominican Republic primarily represents reserve movements rather than exchange rate depreciation. The data also suggest that EMP is higher in the early years of the decade than subsequently. Severe pressures, associated with an electoral campaign, occur between August 1993 and August 1994. During this period gross reserves fell by about US$440 million (from about US$640 million to just under US$200 million), and EMP averaged over 3 percent per month, peaking at 13 percent in August 1994 (compared with an average of less than 1 percent for the 1990–98 period as whole). Thereafter, EMP falls and becomes less variable, despite devaluations in 1997 and 1998.

Table 34.

Exchange Market Pressure and Related Variables

(Period averages, in percent)

article image
Sources: BCRD; and IMF staff estimates.Notes: 1. EMP is defined as exchange rate depreciation plus change in international reserves divided by monetary base 2. Interest rate differential is domestic currency deposit rate minus U.S. (Libor) rate (3-month). 3. Credit variable (δ) is change in central bank credit divided by the monetary base. EMP and δ are percent per month; interest rates are percent per year.

A key determinant of EMP is δt, the growth of the domestic component of the monetary base. If monetary policy is expansionary (δt>mt), EMP will rise (through some combination of reserve movements and exchange rate depreciation). In the Dominican Republic EMPt and δt appear to move together. A positive correlation between EMPt and δt is indicated both by visual inspection (see Figure 13, top) and a simple univariate regression (t-statistics in parenthesis):101

EMPt=0.24(0.57)+0.648(4.17)δt(5)R2(adjusted=0.17)DurbinWatsonStatistic=2.09
Figure 13.
Figure 13.

EMP, Credit Growth (δ), and Interest Rate Differential (ϕ)

(In percent)

Sources: IMF, International Financial Statistics; and IMF staff estimates.

Note that the coefficient on δt statistically differs from zero at the 99 percent level. Presumably, there should also be a relationship between lagged δ and EMPt. However, the regression above examines only the contemporaneous relationship between δt and EMPt. (The relationship between δ and EMP over time is explored in the next section.) According to the adjusted R2 statistic, on a contemporaneous basis alone, 17 percent of EMP is explained by movements in δt.

This finding suggests that δ is an appropriate measure of the stance of monetary policy. However, in much recent work on monetary policy, many authors have used an interest rate, rather than a monetary aggregate like δ, to gauge the stance of monetary policy,102 For a small relatively open economy like the Dominican Republic, the differential between domestic and foreign (U.S.) interest rates Φt, conveys important information: it indicates both expected exchange rate depreciation and a premium required to satisfy the marginal investor. Thus, all else being constant, an increase in Φt (due to contractionary monetary policy) encourages capital inflows and reduces EMP In theory, the relationship between Φ and EMP is ambiguous. On the one hand an increase in Φt may signal anticipated exchange rate depreciation (a Fisher effect) and/or higher risk, reflecting loose monetary policy. In the Dominican Republic, casual inspection suggests that, unlike δt, Φt does not appear to be closely correlated with EMPt, either visually (see Figure 13) or in bivariate regressions.103

EMP and Monetary Policy: AVector Autoregression Approach

As discussed above, one question that this chapter seeks to answer is whether monetary policy in the Dominican Republic affects EMP in the direction predicted by standard monetary theory. In this section, a vector autoregression framework is developed to address this question.

Consider the following VAR system:

Xt=a0+a1Xt1+a2Xt2++vt(6)

where X=(δ, EMP, Φ) is a matrix of variables, ai is a vector of coefficients, and vt=(vδ, vE, vΦ) is a vector of error terms.104 A system like (6) permits testing for effects of past values of X on current values. Assumptions regarding the exogeneity of certain variables (like a policy variable) are easily incorporated into a system like (6). To do so, first assume that each element of the error vector vt is in turn composed of “own” error terms Wt=(Wδ, WE, WΦ) and contemporaneous correlations with “other” errors. That is:

vt=Bwt(7)

where B is a 3 x 3 matrix whose diagonal elements (“own correlations”) equal one and whose nonzero off-diagonal elements reflect contemporaneous correlations among the error terms. Now assumptions regarding the exogeneity of certain variables may be incorporated in restrictions on the matrix B.105

As discussed above, the domestic credit growth variable δ is assumed to be exogenous. That is, in any period, the residual δ(that is, vδ) reflect only the tastes and preferences of the policymaker:

vδt=wδt(8)

Next, errors to exchange market pressure (vE) contain two elements: the “own” shock (wE) plus one related to innovations in domestic credit:

vEt=wEt+b21wδt(9)

Thus, wE may be thought of as a shock to the demand for a country’s currency, due perhaps to changes in investor confidence and sentiment. Thus b21Wδt represents the portion of shocks to EMP that is contemporaneously correlated with domestic credit growth.

Finally, errors to the change in the interest rate differential (WΦ) include the sum of three elements: the “own” shock (WE) plus ones related to innovations in domestic credit and EMP:

vϕt=wϕt+b31wδt+b32wEt(10)

According to equation (10), innovations to domestic credit Wδ affect the interest rate differential through either standard liquidity or Fisher channels. (Thus, the predicted sign of b31 is ambiguous.) Second, the interest rate differential should respond to changes in EMP: a rise in EMP may signal either further exchange rate depreciation in the future, or additional risk, or both. Such effects are captured in the term b32WEt and b32 should be greater than zero. The “own” shock wΦ thus contains other factors not contained in either Wδ or WE This component should be thought of as a “hybrid” that potentially contains both policy- and market-determined elements.106

In addition to the contemporaneous relationships shown in equations (8)–(10), impulse response functions (IRFs) summarize the effect of past innovations (that is, lagged elements of W) to current values of X. Thus, IRFs provide two additional ways to evaluate the effect of monetary policy on EMP. First, IRFs show effects on EMP of both current and past innovations to domestic credit (Wδ). Second, IRFs also show effects on EMP of past (but not current) innovations to the interest rate differential (WΦ). But this latter 1RF may only be thought of as a policy reta-tionship insofar as innovations to the interest rate differential represent policy shocks. (Note also that IRFs show effects on ΔΦ of both current and past innovations to domestic credit and EMP, [Wδ] and [WE], respectively.)

The framework discussed above, however, also helps address the chapter’s third main question, namely, how the stance of monetary policy is determined. Specifically, the IRFs provide a policy reaction function: they show effects on current δ of past (but not current) innovations to EMP (WE) and changes in the interest rate differential (WΦt).107 For example, when faced by positive innovations to EMP (such as a decrease in investor confidence) policymakers may respond “prudently” with contractionary policy (reducing δ). Policymakers might, however, face pressures to act otherwise. For example, when EMP rises, the authorities might also face pressures to provide liquidity to the domestic financial system (raising δ). Such a response, in the context of balance of payments crises and speculative attacks, is discussed in several papers, including Flood, Garber, and Kramer (1996) and Calvo and Mendoza (1996).

Estimation Results

Estimation results are presented in Table 35, Part A, These include adjusted R-squared statistics, exclusion (Granger causality) tests, and IRFs. IRFs are also presented graphically in Table 35, Part B, and Figures 14 through 16. Importantly, estimates confirm that shocks to domestic credit growth (wδ) affect EMP positively, as expected. As Table 35, Part A shows, the hypothesis that lagged 5 does not help explain current EMP is not rejected at conventional levels. Nonetheless (see Table 35, Part B, and Figure 14, top) the current period (period 0) IRF is positive and significantly different from zero at the 99 percent level.108 The results suggest that, contemporaneously, a 1 percent increase (decrease) to domestic credit causes EMP to increase (decrease) by about 1.4 percent. Note that an estimate of unity lies within two standard errors. As a numerical example, with a monetary base equal to US$1.6 billion (the average for 1998), a US$16 million reduction (expansion) of central bank domestic assets implies an approximate US$20 million rise (fall) in international reserves (with a fixed exchange rate). Traditional monetary models suggest that international reserves would rise (fall) by US$16 million, and this amount lies within the confidence interval.

Table 35.

Summary of Estimates, Vector Autoregression System Equation (6)

1992–98 (Monthly Data)

article image
Sources: BCRD; and IMF staff estimates.Note: For all estimates, 4 lags are used. P-statistics in parentheses. δ= rowth of domestic credit (scaled by base money). EMP = exchange rate depreciation plus reserves loss (scaled by base money).ΔΦ = change in interest rate differential.
Figure 14.
Figure 14.

Response of EMP to Shocks1

(In percent)

Sources: IMF, International Financial Statistics; and IMF staff estimates.1 Dotted lines represent plus or minus two standard errors.

In subsequent periods, effects of on wδ EMP remain positive, but with t-statistics below 2. Between months 0 and 5, the cumulative response of a 1 percent increase (decrease) to δ is an increase (decrease) in EMP of about 3¾percent.

Positive shocks to changes in the interest rate differential (wΦ) negatively affect EMP (see Table 35, part B, and Figure 14, bottom). The hypothesis that lagged ΔΦ does not help explain why current EMP is rejected at slightly higher than the 95 percent confidence level. There is an IRF at month 3 that is negative and significant. That is, according to these results, a 1 percent positive (negative) shock to the change in the interest rate differential causes EMP to fall (rise) by about 1 percent, but after three months.

Shocks to EMP (wE) positively affect ΔΦ (see Table 35, part B and Figure 15, top). A positive relationship between We and ΔΦ should not be surprising, as higher (lower) EMP generally indicates higher (lower) expected exchange rate depreciation, risk, or both. Reduced (increased) EMP boosts (lowers) investor confidence and reduces (increases) the domestic interest rate (relative to its U.S. counterpart). The hypothesis that EMP does not help explain current Δф is rejected only at the 80 percent level (as shown in Table 35, Part B). The response, however, of ΔΦ to a shock to EMP after two months equals 0.3 and has a t-statistic of about 2.19. That is, a 1 percent reduction (increase) in EMP reduces (increases) the interest rate differential by about 30 basis points after two months.

Figure 15.
Figure 15.

Response of interest Rate Differential (ΔΦ) to Shocks1

(In percent)

Sources: BCR.D: and IMF staff estimates.1 Dotted lines represent plus or minus two standard errors.

Domestic credit shocks (wδ) appear to have little effect on the change in interest rate differentials (see Table 35, bottom and Figure 15, bottom). Such a finding need not be surprising, given the theoretically ambiguous nature of the link between these two variables, as mentioned in the previous section. The hypothesis that lagged δ does not help explain current Φ is not rejected at conventional levels, and there are no significant responses.

Regarding a policy reaction function, there is little evidence that EMP shocks (WE) systematically affect the growth of domestic credit (δ) (see Table 35, bottom and Figure 16, top). The hypothesis that lagged EMP does not help explain current δ is not rejected at conventional levels. Moreover, no IRF has a t-statistic exceeding |2|. This suggests that the authorities have not been forced to respond, on average, to increased EMP with additional liquidity to the banking system.109

Figure 16.
Figure 16.

Response of Credit Growth (δ) to Shocks 1

(In percent)

Sources: BCRD; and IMF staff estimates.1 Dotted lines represent plus or minus two standard errors.

Likewise, there is little evidence linking shocks to the interest rate differential (wϕ) to δ (see Table 35 and Figure 16, bottom). Rather, the hypothesis that lagged ΔΦ does not help explain current δ is not rejected at conventional levels, and there are no significant responses.

Summary and Policy Implications

This chapter examined the relationship between EMP and monetary policy during the 1990s. Since the exchange rate regime was neither perfectly fixed nor freely floating, it would be misleading to focus exclusively on either reserve or exchange rate movements. Rather, EMP is more appropriate as it summarizes the difference between the growth rates of money supply and demand under managed exchange rate regimes.

This chapter provided evidence on several questions. First, shocks to the domestic credit component of the monetary base have powerful impacts on EMP in the “right” direction: a reduction in δ helps reduce EMP (either by increasing the value of the peso or the stock of international reserves, or both). The response of EMP to interest shocks was somewhat weaker than that linking EMP and domestic credit growth, but also in the “right” direction. These findings, taken together, support the hypothesis that monetary policy is effective in controlling EMP. In a related vein, the chapter provided some insights into the determinants of interest rate differentials, that is. that shocks to EMP positively affect interest rate differentials. This is to be expected, since higher EMP signals both expected exchange rate depreciation and higher risk.

This chapter has three main policy implications. First, the stance of monetary policy, as measured by the growth of the net domestic assets of the central bank (δ), has been an important determinant of EMP. On a contemporaneous basis alone, the growth of central bank domestic assets explains about 17 percent of all movements in EMP. Second, monetary policy is effective in helping to build up reserves. According to the estimates, a 1 percent reduction in the net domestic assets of the central bank will increase reserves (reduce EMP) in the same period by about 1.4 percent. In subsequent periods, there should be additional reserve gains. Numerically, with a monetary base equal to USS1.6 billion (the average for 1998), a US$16 million reduction of central bank domestic assets implies an approximate US$20 million increase in international reserves.110 Third, EMP (primarily reserve movements in the case of the Dominican Republic) feed back to the interest rate differential. The estimates suggest that a US$16 million increase in reserves will reduce the spread between domestic and U.S. interest rates by about 30 basis points.

Stabilization, Structural Reform, and Economic Growth
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