Economic Fundamentals and Monetary Policy Autonomy
28 Pages Posted: 1 Mar 2016
Date Written: 2016-02-24
During a time of rising world interest rates, the central bank of a small open economy may be motivated to increase its own interest rate to keep from suffering a destabilizing outflow of capital and depreciation in the exchange rate. This is especially true for a small open economy with a current account deficit, which relies on foreign capital inflows to finance this deficit. This paper will investigate the underlying structural characteristics that would lead an economy with a floating exchange rate to adjust their interest rate in line with the foreign interest rate, and thus adopt a de facto exchange rate ”peg”. Using a panel data regression similar to that in Shambaugh (QJE 2004) and most recently in Klein and Shambaugh (AEJ Macro 2015), this paper shows that the method of current account financing has a large effect on whether or not the central bank will opt for exchange rate and capital flow stabilization during a time of rising world interest rates. A current account deficit financed mainly through reserve depletion or the accumulation of private sector debt will cause the central bank to pursue de facto exchange rate stabilization, whereas a current account deficit financed through equity or FDI will not. Quantitatively, reserve depletion of about 7% of GDP will motivate the central bank with a floating currency to adjust its interest rate in line with the foreign interest rate to where it appears that the central bank has an exchange rate peg.
JEL Classification: E30, E50, F30, F40
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