Carlos A. Ibarra
Consider now the effect of a capital account shock, for instance in
an exogenous fall in the world demand for domestic assets. This will
appear as an exogenous rise in the rates of interest and exchange. The
rise in q0 and i0 will increase the inflation rate (unless there is a strong
disinflationary effect from the higher interest rate, captured by the
third element in Π). The output effect is likely to be contractionary,
unless a currency depreciation is strongly expansionary. As Equation
(9) shows, in this situation the central bank faces a dilemma arising
from the simultaneous rise in Π (which calls for monetary contraction)
and fall in O (which calls for the opposite response). A tightening will
be the likely course of action to the extent that authorities are strongly
anti-inflationary (high τ).
The policy dilemma can be better understood with the help of Figure
3. The figure shows a negatively sloped schedule for the determination
of the real exchange rate in the (q, i) space. There is also a yT schedule
along which output is kept as a target; the schedule slopes downward
under the assumption that a currency depreciation is contractionary:
the fall in output associated with an interest rate rise has to be offset
by a real exchange rate appreciation. The output schedule is steeper
under the assumption that, after taking into account the effect of an
interest rate rise on the real exchange rate, the net output effect is
contractionary. The target inflation rate schedule is positively sloped
as the inflationary impact of a real currency depreciation has to be
offset by a tighter monetary policy stance.
The real exchange rate schedule shifts out as a consequence of the
posited capital account shock. At the same time, the market interest
rate rises. If, as seems plausible, the shock results in higher inflation
and lower output, the economy will move to a position along the 1-2
segment of the q schedule. The authorities may respond with a
monetary expansion, pushing the economy toward point 3, or they
may instead adopt a more restrictive policy stance, moving toward
point 2. In the first case, output is protected at the cost of higher
inflation, whereas in the second the authorities are inclined to stick
with the inflation target and are willing to sacrifice output. The actual
choice will depend on policy preferences, as shown by the role of
parameter τ in our previous discussion. But the policy response may
also be conditioned by the behavior of private expectations.
To see this, first note that if the authorities choose to move toward
point 3 by adopting a looser policy stance, and if they are successful in
raising the real exchange rate, this implies that there will be a rise in
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