ACTIVE EXCHANGE rate management has become increasingly prevalent among developing countries in recent years. With a view toward preserving competitiveness, these countries have frequently adopted rules under which the nominal exchange rate is depreciated continuously to offset differences between domestic and foreign inflation rates. Because such rules, which effectively target the real exchange rate, establish a feedback from domestic inflation to the nominal exchange rate, countries adopting them sacrifice the role of the exchange rate as the nominal anchor for the price level. Since price level stability remains an important macroeconomic goal in such countries, the question naturally arises as to whether the role of nominal anchor can instead be provided by a policy-controlled financial aggregate, such as the money supply.
In an earlier paper (Montiel and Ostry (1991)), we investigated the effects of real shocks on price level stability under real exchange rate targeting.1 We found that the stock of domestic credit could not replace the exchange rate in the role of nominal anchor under such a regime. While the money supply may represent a more obvious candidate for this role, our previous paper incorporated the assumption of perfect capital mobility, which prevented the authorities from treating the money supply as a policy variable. To examine the implications of money supply targeting under a real exchange rate rule, we now consider the case in which capital controls are imposed, thereby making sterilization feasible, and ask whether fixing the money supply can stabilize the price level in response to shocks. The analysis leads naturally to a consideration of the case in which the effectiveness of capital controls is less than perfect, and we examine the implications of money supply targeting in this case as well. We find that using money as a nominal anchor is problematic in both cases.
The paper is organized as follows: the next section presents an abbreviated description of our previous model, modified for the presence of effective capital controls, and demonstrates the inflationary consequences of a real—specifically, a terms of trade—shock in the absence of money supply targeting. The money supply is then fixed through a policy of active sterilization in Section II, and the macroeconomic implications of the terms of trade shock are reexamined under these circumstances. Section III considers how the analysis is affected when capital controls are imperfect. Our findings regarding the role of money as a nominal anchor are summarized in a brief concluding section.
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Peter J. Montiel was Deputy Division Chief of the Developing Country Studies Division of the Research Department when this paper was written and is currently Danforth/Lewis Professor of Economics at Oberlin College. He is a graduate of Yale University and the Massachusetts Institute of Technology.
Jonathan D. Ostry, an Economist in the Research Department, holds a doctorate from the University of Chicago, as well as degrees from the London School of Economics and Political Science, Oxford University, and Queen’s University.
The authors would like to thank Guillermo A. Calvo and Mohsin S. Khan for useful comments.
In the absence of terms of trade shocks, π* is the foreign currency rate of inflation of traded goods, which will be referred to in what follows simply as the foreign inflation rate.
We have suppressed the real exchange rate as an argument from the supply of nontradables function, since, under the real exchange rate rule, this relative price does not change.
The private sector budget constraint assumes that inflation tax revenues that accrue in the first instance to the central bank are not handed back to the private sector. This assumption was necessary to ensure the existence of a unique steady state in our previous paper (Montiel and Ostry (1991)), and is also necessary under the assumption of imperfect capital mobility. A related point is made by Woodford (1988) in his discussion of the macroeconomic effects of pegging the interest rate.
The instability of the system defined by
Our comparative statics results with respect to inflation do not, however, depend on the assumption that the SS schedule is negatively sloped. If the slope of SS is positive, then the result requires only that SS be steeper than NN, which is assured by previous assumptions.
The fact that
Again, our comparative statics results do not depend on this assumption.
Notice that this condition is equivalent to the requirement that the product of the share of seigniorage in real income and the income elasticity of money demand be less than unity, something that would be easily satisfied for any plausible values of the parameters.
By contrast, under a fixed exchange rate regime, this shock would lead to a real exchange rate appreciation in the model, with no change in the steady-state rate of inflation (see Khan and Montiel (1987)).
In this case,
Recall the assumption, i* = π*.
If the central bank extends credit to the government, m – dp is reserves plus credit to the government; in either case, m – dp is positive.
As mentioned previously, all results are evaluated around an initial steady state with b = 1.
We assume that the
The magnitude of the shift is given by
This can be shown as follows. Totally differentiating equation (5) under the assumption of perfect capital mobility, so that b = 1 (and therefore b = 0), we have
Since m + w cannot jump at the moment that controls are abandoned, equation (5) implies that b also cannot change discontinuously.