International Capital Flows and Destabilizing Fiscal and Monetary Policy

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International Capital Flows and Destabilizing
Fiscal and Monetary Policy

• Jose Ricardo da Costa e Silva
• Central Bank of Brazil

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Disclaim

• The views expressed in this work are those of
  the author and do not reflect those of the
  Central Bank of Brazil or of its members

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Introduction

• Motivation
• Developing countries experience larger
  macroeconomic volatility than developed nations.
• Literature suggests that this volatility results
  in strong welfare losses.
• Literature suggests that unstable capital flows
  and pro-cyclical fiscal policy is one of the
  reasons for macroeconomic volatility in
  developing countries, in especial Latin American
  Countries.

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Introduction

• Objective
• Examine whether Latin American countries practice
  destabilizing pro-cyclical fiscal and monetary
  policy, avoiding problem with endogenous
  regressors.
• Analyze the influence of international capital
  flows on the destabilizing policy.

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Literature Review

• Literature on Pro-cyclical Capital Flows
• Finance and business cycle in domestic economy
  Gertler (1988), Bernanke and Gertler (1989).
• Diaz-Alejandro (1983, 1984), Griffith-Jones and
  Sunkel (1986), Calvo and Reinhart (1999),
  Caballero (2000, 2002), Ocampo (2002, 2002),
  Eichengreen (2003).
• Gourinchas (1999), Aghion, Bacchetta and Banerjee
  (1999).
• Fernandez-Arias and Panizza (2001), Calderon and
  Schmidt-Hebbel (2003).
• Ffrench-Davis (2003).

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Literature Review

• Literature on Pro-cyclical Fiscal Policy
• Aizenman, Gavin and Hausmann (1996), Talvi and
  Vegh (2000) and Riascos and Vegh (2003).
• Gavin, Hausmann, Perotti and Talvi (1996), Gavin
  and Perotti (1997), IMF (2002), Calderon and
  Schmidt-Hebbel (2003), Kaminsky, Reinhart and
  Vegh (2004).
• Carvalho (2000), Godfajn (2001), Ocampo (2002,
  2003).

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Brazil ?0.46
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United Kingdon ?-0.11
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Literature Review

• Literature on Pro-cyclical Monetary Policy
• Calvo and Reinhart (2000), Caballero (2002a).
• Calderon and Schmidt-Hebbel (2003).
• Carvalho (2000), Gomez (2001).

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Rationale

• Rationale for Pro-cyclical Monetary Policy
• Fixed Exchange Rate
• Floating Exchange Rate
• Floating with inflation-targeting
• Fear of Floating.

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Rationale

• Rationale for Pro-cyclical Fiscal Policy
• Unfulfilled demand for social and structural
  investments
• Increase in international liquidity
• Increase in revenue
• Increase in borrowing
• Less interest payment, more revenue to be used in
  goods and services
• In bad times tight fiscal policy is sign of
  credibility.

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Econometric Models

• Pro-cyclical Monetary and Fiscal Policy
•        GMM
• Policyt a0 a1?GDPt a2Policyt-1 a3Xt
  et,
• with ?GDPt-1 as instrument
•        VAR

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Econometric Models

• Pro-cyclical Monetary and Fiscal Policy during
  Good and Bad moments
• -       GMM
• Policyt a0 a1?GDPtDgood a1?GDPtDbad
  a2Policyt-1 a3Xt et, with ?GDPt-1Dgood and
  ?GDPt-1Dbad as instrument
• VAR
•  Policyt C a1?GDPt-1Dgood a2?GDPt-1Dbad
  a3Policyt-1 ßXt et
• ?GDPt C b1?GDPt-1Dgood b2?GDPt-1Dbad
  b3Policyt-1 ßXt et

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Econometric Models

• Impact of Capital Flow on Fiscal and Monetary
  Policy
• -       GMM
• Policyt a0 a1Capital Flowst a2Policyt-1
  a3Xt et
•  
• -       VAR

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Policy Directions and International Capital
Influence
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Policy Directions and Capital Influence under
Different State
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Conclusions

• Developing countries follow destabilizing
  pro-cyclical policy.
• Data does not show same pattern of pro-cyclical
  policy in developed countries.
• Capital flows seems to affect policy decisions in
  these economies in a pro-cyclical direction.
• Case of Chile indicates that even when capital
  flows impact fiscal policy in a pro-cyclical
  direction, if country have an effective savings
  action during good times, it may be able to
  implement counter cyclical policy (support to
  Talvi and Vegh (2000)).

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Policy Implications

• To reduce the chances/impact of pro-cyclical
  policies
• Increase public savings during good times may
  reduce chance of pro-cyclical fiscal policy.
• Flexibly monetary target during sudden stop may
  reduce the pro-cyclical aspect of monetary
  policy.
• Prudential regulation in capital mobility may
  help reduce the destabilizing effect of capital
  flows.
• Development of domestic financial system reduces
  dependence for international financial flows and
  so the consequences of the pro-cyclical flows.