ECON430-Topic #1: Developing Nation Monetary Policy

Developing nations like China and Turkey are forced to use different monetary policy instruments than in the United States, which makes their policies a bit more difficult to understand than in the United States. Even small developed countries like Switzerland do not have the freedom to conduct monetary policy as they wish at all times. In the U.S., prior to 2008 the Federal Reserve would cut the federal funds target rate when they wanted to raise output and inflation, and raise the rate when attempting to cut output and inflation. Since the U.S. financial crisis and Euro crisis global monetary policy has been more difficult and less straightforward for developing and/or small developed nations due to the ‘hot money‘ that has been moving around the globe.

Several countries have been forced to resort to policy that would appear to conflict with the goals that are set for monetary policy. For example, following a recent earthquake in China, the PBOC (People’s Bank of China) cut reserve requirements to banks in that province. This should increase lending in those areas, but what about their overall concern about inflation? In Turkey, their central bankers have been trying to fend off high inflation there, while also cutting interest rates to back expansion. In Brazil, their central bank has been attempting to pull off a similar feat of raising output while stemming high inflation. Swiss central bankers have faced a somewhat different problem as those fearing the breakup of the Euro or weakness elsewhere flooded the Swiss market with funds. The Swiss central bank responded by fixing their exchange rate to keep it temporarily weaker than it would otherwise be to help keep their foreign trade balance in line. These international issues have often arisen because of the U.S. policy of low interest rates and quantitative easing over the last several years.

Try to use the following terms correctly in your posts. Note that central banks have ‘instruments’ which they use to impact ‘targets’ which ultimately helps them reach their ‘goals’. In the U.S. the Fed typically uses the open market operation instrument, to move the federal funds rate towards their target, hoping to ultimately reach their goal of full employment and stable prices.

Questions you might consider

  • What do you think is the main reason that the PBOC uses reserve requirements as a primary instrument of monetary policy? What tools has Turkey used in addition to reserve requirements so that they can raise interest rates on overnight lending? How are these tools similar across countries?
  • Does the U.S. economy’s return to health through unusual monetary policy ultimately benefit countries like Turkey, South Africa, Indonesia, India, Brazil, or Jamaica more than it would if the Fed didn’t do anything at all? Would we expect capital outflows from the U.S. even if the Fed hadn’t done anything in 2008-2014?
  • Wearing a “classical” hat for a moment, is the Fed even able to impact the U.S. economy in a meaningful way? If not, then why are they able to impact foreign countries in an even more substantial way?
  • How has the Swiss exchange rate peg affected their people and trade balance in the last few years. How would they have likely fared if they hadn’t done anything at all and let their exchange rate strengthen as predicted?

Remember, don’t try to answer all of these questions, just focus on one, provide some evidence, and support your opinion.

12 thoughts on “ECON430-Topic #1: Developing Nation Monetary Policy”

  1. Switzerland is a banking haven for investors, funds, and governments around the world. They are predisposed to asset inflows and outflows during times of financial stress because of their banking history. Expectations move markets, and the fear of the breakup of the Euro has people transferring funds. While the US is the number one reserve currency in the world, the Swiss Franc is not far behind. The demand for Francs as a hedge against euro uncertainty has flooded Swiss banks with foreign assets. The SNB (Swiss National Bank) has responded by buying foreign assets to decrease demand relative to other currencies. This would indicate an increase in debits in the government’s capital/financial account, or an increase in net claims on Switzerland thus increasing imports. Even though this would increase imports, Switzerland boasted a CHF 3.98 billion surplus. Had the SNB not tried to peg exchange rates, that number may have been drastically different. With the appreciation of its currency, Switzerland would face great losses to their exports. Trade would slow, and a somewhat stagnant economy would not help. With the 3-month CHF libor, a key benchmark rate for the SNB, nearing zero and a zero percent inflation rate, Switzerland needs to keep its exports strong in order to maintain high status among the financial elite. Although Switzerland would have had a setback with exports if they allowed the CHF to appreciate, their goods are still widely admired by firms and individuals all over the world. Higher quality items will always have a market, and because Switzerland is geographically diversified in trade, they have steady demand.


  2. The reserve requirement in China is frequent to change unlike most countries. The Chinese use the reserve requirement ratio as a way to manage their targeted economic growth. China has a booming economy due to its high volume of exports and low imports, but this rapid growth leads to a high inflation in the country. To counteract the inflation the PBOC often changes the reserve requirement to alter the amount of money in circulation and control the amount of lending. Currently China is using “targeted and gradual” reserve ratio cuts. This is being done so that China can meet a goal of 7.5% economic growth while keeping inflation under control. The cut in the reserve ratio will hopefully bring new loans to China worth roughly $80 billion and keep the money supply still at a reasonable level. This is also why China is cutting the reserve requirements in the quake-hit zone. The earthquake damaged business and agriculture sectors which slowed the economic activity in the region. To bounce back and reach the targeted growth these areas are being assisted with an extra cut in reserve requirements. This cut should expand bank credit and decrease interest rates which will help the quake-hit economies to recover.


  3. When looking at a classical approach, the obvious answer is that Fed intervention is not needed and that all markets will adjust automatically. But Fed decisions can have major impacts on other countries. But to look at it in a more specific way, there has been evidence that the Federal Reserve’s “decisions” on interest rate and money supply targets have a direct impact on other central bank’s decisions. Economist John B. Taylor of the WSJ, has written multiple articles on how the Fed’s decisions in the past decade have led to the European Central Banks decisions during the recession in 2008. Taylor created a regression and it was statistically significant showing that the Fed’s decision to target an extremely low interest rate from ’03-’05 led the ECB to target for a low interest rate as well. Taylor also tries to prove that if this target wasn’t so low, there would be less monetary excess and the extreme boom and the bust in the 2000’s would not have happened. He says that with this low interest rate that the Fed targeted, people aimed toward s riskier investments and caused the extreme fluctuations in the market. This shows that even with a classical approach that the Fed policies have no impact on the economy, it would be hard to argue that the low targeted interest rates didn’t impact the fluctuations of the market in the 2000’s.


    The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong –John B. Taylor

  4. China is using their reserve requirements as their main source of monetary policy simply because other options were taken away, and it’s not helping their goals. Earlier this year, the government’s hand was removed from borrowing cost decisions which led to alternative policy instruments. The alternative, reserve requirements, was lowered in hopes of increasing the money supply and reaching their targeted high inflation. This was met with little success and prices persistently dropped. As they continue to search for available policy alternatives, the PBOC should look into quantitative easing. They no longer have a direct connection to controlling borrowing costs, but purchasing financial assets will raise prices, decrease yields, and ultimately add to the desired money supply. This would influence borrowing costs indirectly and also combat some of the problems that China has with shadow banking. The yields on shadow banking have risen to exorbitant amounts, but is already overseen by the China Banking Regulatory Commission and can be taken a step further. The Commission should aim to influence these markets of trusts and financial assets following the United States’ example, ultimately ending in higher prices and lower yields. While China might have been stripped of some of their monetary oversight, simply switching to the nearest policy is not going to help their policy goals, targeting assets over loans will.

  5. Turkey’s recent economic status has been very dependent on the international markets. The high use of hot money flowing in Turkey’s market has caused the lira to fluctuate in value quickly. Also, the speculative attack that drove the demand for the lira down recently has been a concern of the Turkish economy. The main concern of the Central Bank of the Republic of Turkey is domestic price stability, which depends on the volatility of the exchange rate of the lira. Turkey is currently using two types of monetary policy in addition to reserve requirements: the interest rate corridor and the reserve option mechanism.

    The interest rate corridor’s main goal is to smooth international capital flows by having a small uncertainty about the interest rate of lending and borrowing. By having a range of what the discount rate and interest on reserves can be the CBRT effectively creates a corridor of what the interest rate is expected to be. Because of this range, the interest rate has more flexibility, smoothing capital inflows because there is less speculation about the interest rate.

    The reserve option mechanism is the option to hold FX or gold in place of lira for the CBRT reserve requirements. This tool also levels capital inflows by making banks less delicate to the volatility of the lira. The reserve option mechanism creates less volatility hot money flows to enter the market. The mechanism creates more of a backing to resist a potential speculative attack, because if banks need to buy back the lira they have other forms of currency to do so with, making the lira safer.

  6. According to 18th century classical economist Adam Smith, there is no need for government intervention in the market place due to a phenomenon known as “the invisible hand”. Individuals pursuing their own interest often times indirectly promote the good of society and this causes markets to clear and reach equilibrium on their own. However, with the increased globalization of the world economy in recent decades, the Federal Reserve’s monetary policy no longer effects only domestic markets, but international markets as well. According to William C. Dudley, President of the Federal Reserve Bank of New York, “our actions often have global implications that feed back into the U.S. economy…We need to be careful not to underestimate the consequences of our actions”. What Dudley is explaining in his March 2014 Roundtable Discussion is that given the size and power of the Fed and given the role of the dollar as the global reserve currency, the US has a responsibility to manage policy in a way that not only promotes stability in the US but the entire global economy as well. While classicalists may think the Fed’s policies have no implication on the economy, this feedback effect proves otherwise. Monetary policy spillovers occur both among advanced economies and emerging economies. For example, the recent rise in longer term interest rates in the United States last summer was correlated with increased pressure on forward rates with the euro, which caused the European Central Bank to engage in forward guidance. This in turn resulted in the decoupling between the euro and US forward money market rates. This goes to show that not only does US monetary policy impact foreign countries, but it creates a feedback cycle that in turn effects the US again.

  7. Since the global financial crisis, Turkey has been struggling to find the correct monetary policies that will bring down its staggering inflation. The expansionary policies adopted by the central banks of developed countries following the crisis, led to rapid credit expansion and appreciation pressure on the Turkish lira. This appreciation in currency created global imbalances and a threat of financial instability. As a result, in 2010, the Central Bank of the Republic of Turkey (CBRT) modified the general framework of its monetary policy while retaining the objective of maintaining price stability by targeting inflation. Other than reserve requirements, one of the instruments that the central bank has been utilizing to target inflation is the interest rate corridor between overnight borrowing and lending.
    In October 2011, the lira sank 20% against the dollar and inflation hit double digits. In response, the central bank sharply raised the overnight lending rate by 350 basis points to 12.5%. Again, in January of 2014, the central bank aggressively increased overnight lending and interest rates to defend the tumbling lira. More recently, the central bank exercised its instrument differently, and unexpectedly lowered its overnight lending rate. According to Erdem Basci, the head of the central bank, the utilization of the interest rate corridor is showing small signs of effectiveness through the continued growth of loans and moderate capital inflows from abroad. However, Turkey has not seen its inflation rate drop below 9% in over five months, and subdued economic growth numbers for the second quarter imply that rate cuts have not been as effective as intended at sparking domestic demand.
    Since Tayyip Erogani, Turkey’s newly elected president, argues opposite to conventional economic theory that higher interest rates cause inflation, with the lower than expected growth numbers, it is likely that the central bank will continue to receive added pressure to cut rates. However, in a time of major geopolitical risks and with stubbornly high inflation, cuts that happen too quickly could jeopardize the long-term health of the Turkish economy.

  8. Under Classical conditions, the Fed is unable to impact the U.S economy in any way since under the quantity theory of money, any change in the quantity of money will lead to a proportional change in the price level immediately. Even though the Fed is unable to affect their own economy, foreign economies do reap the affects. When the Fed set the interest rate close to zero, emerging markets were hit hard with capital inflows by investors trying to gain from the high interest rates. This causes these volatile emerging markets’ currency to appear stronger than they actually are which will cause net exports to fall. Economist, Elod Takats came up with a regression to show how U.S. policy affects rates in emerging markets and found that U.S policy parameter is significant for emerging markets. Many emerging markets such as India and Singapore lowered their interest rates than desired to close the gap in net-exports which hinder their long term goal in growth.

  9. The use of unusual monetary policy by the Fed (and other central banks) is widely accepted as the appropriate policy response to such an immense shock to the global economy as seen in 2008. The Fed and Treasury acted as the lender of last resort to calm markets and ease financial conditions. As a result, they prevented the credit markets from “drying up” which would have stalled American businesses and crashed the global financial system. Many prominent economists estimate that these unconventional policy tools have improved GDP by between 1 & 3 percent, reduced the unemployment rate by roughly 1 percent and prevented deflation.

    But what was the impact on emerging economies such as Brazil, Turkey, and South Africa? This analysis must be done on a country by country basis with key themes in mind such as (but not limited to) their dependence on foreign investment, their reliance on natural resources, and the state of their current account. A country such as Turkey runs a current account deficit and depends a great deal on foreign trade with advanced economies. As a result of this interdependence, Turkey’s GDP growth declined 7.57% in 2009. On the surface this seems bad, but imagine the impact if central banks had not stepped in and stopped the global economy from a free fall.

    Although these unusual monetary policies prevented a global depression, they did create challenges for emerging markets (EM) in the form of hot money flows. These hot money flows created EM exchange rate volatility therefore creating volatility in domestic inflation rates and individual trade balances. This has created challenges for central banks to implement effective policy tools that limit exchange rate volatility and contain inflation while also stimulating economic growth. Even though these policies have created challenges for EMs, ultimately they are just minor bumps when compared to the alternative scenario of no policy action at all.


  10. Thinking like some of the greatest philosopher-economists such as Hume, Smith, and Ricardo the Fed impacts the U.S. economy by conducting a special type of monetary policy which cuts interest rates and raises the monetary base. They do this simply by buying and selling short-term bonds. As said in Chapter 2 of The Federal Reserve System: Purposes and Functions, “In the short run, some tension can exist between the two goals of stabilizing prices and promoting output and employment.” “In such circumstances, those responsible for monetary policy face a dilemma and must decide whether to focus on defusing price pressures or on cushioning the loss of employment and output.” The fed is able to do all this with three simple monetary policy tools: open market operations, the discount rate, and reserve requirements. The impact may not be meaningful from a classical viewpoint since it is contra to their belief that if money supply increases then prices increase. The bigger countries will follow “General Equilibrium” and return back to equilibrium given a set of prices.
    This “special” monetary policy has made it very difficult for smaller countries such as Turkey, Brazil, and Jamaica that are fighting soaring inflation rates. However, countries like Switzerland have found a way to keep prices stable, by keeping a fixed exchange rate, says Reuters. The fixed exchange rate allows the Swiss National Bank to retain the value of their currency. The fixed exchange rate doesn’t harm the bigger country. This wraps up the discussion with the idea from David Hume that, increasing money supply increases economic activity in the short run and we still see this occurring in countries of all shapes and sizes (economic).
    -Babar Syed

  11. The unusual tactics that the Fed employed stimulated emerging markets such as Brazil, India, and Turkey. Now that the hot money moved back to more developed economics, emerging markets are crying foul. But where were these concerns when it was flowing in?
    Yields on a 10-year US treasury went from 3.36%, at the start of 2011, all the way down to 1.89% at the end.1 This low-interest environment that the Fed created caused investors to go abroad in search of higher yields. This large flight of capital did cause asset prices to get inflated in EM’s but it also gave them access to cheap capital. GDP growth in India, Brazil or Turkey has not been lower than it was in the period between 2008 and 2009.2
    There were unintended negative consequences of the flow of hot money such as currency wars and exchange rate volatility. But if emerging markets wanted to restrict the flow of money in, they could have through capital controls but they didn’t because that flow of money spurred their economy like nothing else could.
    If the Fed hadn’t kept rates unusually low and just done nothing, then investors would have piled in to US treasuries, accepting lower yields in exchange for a safe return. Some money would have gone abroad as the piling in to treasuries would have caused yields to drop. But the Fed made rates so low that investors almost had no choice. Accounting for inflation, the real return would have been almost negligible. If the Fed had done nothing, then emerging markets wouldn’t have anywhere near the access to cheap capital as they did and their economies would have been the worse for it.




  12. Through the classical school of thought, the actions taken by the Federal Reserve are unable to change the state of the economy. Due to the neutrality of money, Fed policies like QE1-4 and TARP (for example) would only increase the price level in the economy and would not affect real expenditures and growth. As the abundance of currency ensues, money will become increasingly meaningless and will only make real assets become nominally more expensive. This lack of efficacy in Fed policy has not been seen because the United Sates was not subject to inflation over the course of the recovery from the 2008 recession. But, ripples are evident throughout international markets.

    Since the Bretton Woods conference in July of 1944, the US Dollar has been the primary IRA (international reserve asset) of the world. Since 1944, the United States has been the source of international liquidity in the financial market. Every country wants to have US$ to buy our assets. Because many countries fix their currency to the US$, whatever policies the Fed implements effect many emerging markets. For example, the Fed reduced its asset buyback program from $65 billion to $55 billion per month in March of 2014. This tapering led to a reduction in capital inflows into countries like Turkey and South Africa that rely on outside money to fund their growing capital account deficits. Turkey is currently combating massive inflation even through contractionary monetary policy. They need the capital inflows from Quantitative Easing to increase accessible credit and support such a monetary policy. As John C. Williams, president of the Federal Reserve Bank of San Francisco, said “In the end of the day, we live in a modern, global financial system and this is…in terms of monetary policy in the United States having effects outside the United States.”

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