International Liquidity Management: Sterilization Policy in Illiquid Financial Markets

48 Pages Posted: 26 Jul 2000

See all articles by Ricardo J. Caballero

Ricardo J. Caballero

Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER)

Arvind Krishnamurthy

Northwestern University - Kellogg School of Management

Multiple version iconThere are 2 versions of this paper

Date Written: May 2000

Abstract

During the booms that precede crises in emerging economies, policy makers often struggle to limit capital flows and their expansionary consequences. The main policy tool for this task is sterilization--essentially a swap of international reserve for public bonds. However, there is an extensive debate on the effectiveness of this policy, with many arguing that it may be counterproductive once the (over-) reaction of the private sector is considered. But what forces account for the private sector's reaction remain largely unexplained. In this paper we provide a model to discuss these issues. We emphasize the international liquidity management aspect of sterilization over the traditional monetary one, a re-focus that seems warranted when the main concern is external crisis prevention. We first demonstrate that policies to smooth expansions in anticipation of downturns can be pareto improving in economies where domestic financial markets are underdeveloped. We then discuss the implementation and effectiveness of this policy via sterilization. The greatest risk of policy arises in situations where policy is most needed--that is, when financial markets are illiquid. Our mechanism is akin to the "implicit bailout" problem, although the central bank acts non-selectively and only intervenes through open markets in our model. Illiquidity replaces corruption and ineptitude. In addition to an appreciation of the currency and the emergence of a quasi-fiscal deficit, the private sector's reaction to sterilization may lead to an expansion rather than the desired contraction in aggregate demand or nontradeables investment and to a bias toward short term capital inflows. The main insights extend to international liquidity management issues more generally.

JEL Classification: E590, F310, F340, G380

Suggested Citation

Caballero, Ricardo J. and Krishnamurthy, Arvind, International Liquidity Management: Sterilization Policy in Illiquid Financial Markets (May 2000). Available at SSRN: https://ssrn.com/abstract=229579 or http://dx.doi.org/10.2139/ssrn.229579

Ricardo J. Caballero (Contact Author)

Massachusetts Institute of Technology (MIT) - Department of Economics ( email )

50 Memorial Drive
Building E52-528
Cambridge, MA 02142
United States
617-253-0489 (Phone)
617-253-1330 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Arvind Krishnamurthy

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States
847-491-2671 (Phone)
847-491-5719 (Fax)