Carlos A. Ibarra
fall in foreign investment). Figure 4 illustrates the point. In the figure
it is assumed that inflation is relatively more sensitive than output to
variations in the real exchange rate, in the sense that after q rises,
returning to target inflation requires a larger interest rate increase
than returning to target output. If the capital account shock is
contractionary, the economy will shift to a point along the 1-2 segment.
There is thus again a policy dilemma.
The preceding discussion stresses the point that, if the central
bank behaves in anti-inflationary fashion after an exogenous decline
in the currency’s value, then interest rates will increase for some time.
But in addition there may be a more immediate effect through
variations in private expectations. In particular, if private agents
believe that the central bank will adopt tighter policies in the near
future, then standard term structure theory predicts that current
interest rates (except those for very short-term instruments) will start
moving upward (even if the uncovered interest parity condition holds;
see Ibarra 2002). This is a channel that may be of importance in the
Mexican case, given that the Cete rate has not been a central bank
instrument during the float.
IV. Conclusions
The possibility of having an autonomous monetary policy under
conditions of high international mobility of capital, and the output
stabilizing properties of a floating currency regime, depend on the
way interest rate differentials react to exogenous variations in the
exchange rate. An adverse capital account shock, for instance an
exogenous fall in the world demand for local assets, besides having a
negative output effect, reduces the local currency’s international value.
If the latter leads to a decline in the expected depreciation rate for
some future date, then current interest rates (aside from those on
very short-term instruments) will tend to fall. This interest rate
adjustment would be an automatic output stabilizer embedded in the
floating regime. Even more, the negative correlation between the
current exchange rate and the interest differential would give the
central bank the leeway to assume a clear anti-cyclical policy stance.
In this paper we have estimated, from an ECM, the dynamic
response of the interest rate gap between Mexican and US Treasury
bills to a permanent variation in the exchange rate, using data from
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