More Slides from Ed Dolan’s
Econ Blog http://dolanecon.blogspot.com/ The Impossible Trinity, or, Why Latin America Hates QE2 Posted January 19, 2011 Terms of Use: These slides are made available under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics , from BVT Publishers.

Latin America Up in Arms
over QE2 <ul><li>Latin America is up in arms over the Fed’s program of quantitative easing, known as QE2 </li></ul><ul><li>Brazil and Chile, among the most affected countries, have undertaken actions to protect their economies </li></ul><ul><li>Why the harsh reaction, when most people in the United States view QE2 as a purely domestic policy designed to reboot a faltering economic recovery? </li></ul>Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com “ This is a currency war that is turning into a trade war.” — Guido Mantega Finance Minister of Brazil Photo source: Agencia Brasil, http://commons.wikimedia.org/wiki/File:Guido_mantega.jpg

Making Waves <ul><li>Fact No. 1:
There is no such thing as purely domestic monetary policy in today’s world </li></ul><ul><li>Central bank actions of even the smallest countries create ripples in the global financial system </li></ul><ul><li>The Fed’s actions can create bigger waves </li></ul>Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com Photo source: Malene Thyssen, http://commons.wikimedia.org/wiki/User:Malene

How QE2 Affects the Global
Economy <ul><li>The Fed’s purchases of longer-term Treasury securities under QE2 tend to reduce yields on those securities </li></ul><ul><li>Paying for the purchases increases bank reserves, putting additional downward pressure on US interest rates </li></ul><ul><li>When US interest rates fall, some investors look for better opportunities abroad </li></ul><ul><li>Countries like Brazil, Chile, and others experience increased financial inflows </li></ul>Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com The Federal Reserve Building in Washington, D.C. Photo source: AgnosticPreachersKid, http://commons.wikimedia.org/wiki/File:Marriner_S._Eccles_Federal_Reserve_Board_Building.jpg

The Impossible Trinity <ul><li>According to
the “impossible trinity,” a country can choose only two of the following three: </li></ul><ul><li>An independent monetary policy </li></ul><ul><li>An open capital account </li></ul><ul><li>A fixed exchange rate </li></ul>Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

Effects of Financial Inflows: Variant
1 <ul><li>If a country chooses an independent monetary policy and an open capital account, it must have a floating exchange rate </li></ul><ul><li>An increase in financial inflows will cause its exchange rate to appreciate </li></ul><ul><li>Consumers and other buyers of imported goods will benefit, but exporters and manufacturers that compete with imports will suffer </li></ul><ul><li>If the political influence of exporters and import-competitors is disproportionately great, as is often the case, then the political reaction to currency appreciation will be mostly negative </li></ul>Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

Effects of Financial Inflows: Variant
2 <ul><li>If a country chooses a fixed exchange rate and an open capital account, it loses independent control of monetary policy </li></ul><ul><li>When financial inflows increase, the central bank must buy foreign currency in order to prevent exchange-rate appreciation </li></ul><ul><li>It pays for the foreign currency with newly created domestic money </li></ul><ul><li>The increased money supply causes inflation, which, in turn, undercuts the competitiveness of exports </li></ul><ul><li>This combination of a fixed nominal exchange rate plus inflation can also be described as real appreciation of the country’s currency </li></ul>Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

Effects of Financial Inflows: Variant
3 <ul><li>A country can maintain fixed exchange rate and use its monetary policy independently to control inflation if it closes the capital account and blocks unwanted financial inflows </li></ul><ul><li>Orthodox economics has tended to frown on this option because cutting off financial inflows can deprive the economy of a vital source of capital </li></ul><ul><li>In that case, stability of the exchange rate and the price level comes at the expense of slow economic growth </li></ul>Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

Compromise policy: Partial capital controls
<ul><li>Some countries, including Brazil and Chile, have tried a compromise policy that partly restricts financial inflows without completely closing the capital account </li></ul><ul><li>The idea is to filter out unwanted, short-term, speculative “hot money” while allowing inflows of growth-promoting, long-run direct foreign investment </li></ul><ul><li>These controls may help in the short run, but they may lose their effectiveness over time </li></ul>Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

Compromise policy: Sterilization <ul><li>Another possible
compromise, currently being used by Chile, is to “sterilize” foreign exchange market intervention </li></ul><ul><li>A central bank is said to sterilize when it buys foreign currency to resist appreciation, and then neutralizes the monetary effects by selling bonds or other non-monetary financial instruments </li></ul><ul><li>However, sterilization can be very expensive and may not work well for more than short periods </li></ul>Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

Why South America Hates QE2
<ul><li>The impossible trinity makes it easier to see why South American finance ministers and central bankers do not like QE2 </li></ul><ul><li>QE2 causes increased financial inflows, which cause unwanted inflation and exchange rate appreciation </li></ul><ul><li>Countermeasures can be taken, but because of the impossible trinity, all countermeasures involve costs and compromises </li></ul>Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com Photo source: NASA, http://commons.wikimedia.org/wiki/File:South_America_satellite_plane.jpg

But QE2 is Only Part
of the Problem <ul><li>However, QE2 is only one among many sources of Latin America’s problems </li></ul><ul><li>As this chart shows, the trend toward real exchange rate appreciation was underway long before QE2 </li></ul><ul><li>Other causes of currency appreciation in Latin America: </li></ul><ul><ul><li>Dynamic, well-managed economies that offer many investment opportunities </li></ul></ul><ul><ul><li>Increases in world commodity prices during recovery from the global financial crisis </li></ul></ul>Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

The Bottom Line: Ripples, but
not a Tsunami <ul><li>The bottom line: </li></ul><ul><li>QE2 may make life a little harder for Latin American policy makers, but they have other problems as well </li></ul><ul><li>QE2 is making ripples in the world financial system, but hardly a tsunami </li></ul><ul><li>QE2 is not the start of a global currency war; It is a domestic program with moderate but unavoidable external effects </li></ul><ul><li>In the long run, if QE2 works to speed recovery, US trading partners everywhere will benefit </li></ul>Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com