the impossible trinity, or, why latin america hates qe2
DESCRIPTION
Latin America has reacted negatively to the Fed's program of quantitative easing (QE2), calling it "currency manipulation," "currency war," and worse. This slideshow explains why, using the economic principle of the "impossible trinity."TRANSCRIPT
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The Impossible Trinity, or, Why Latin America
Hates QE2Posted January 19, 2011
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Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com
Latin America Up in Arms over QE2
Latin America is up in arms over the Fed’s program of quantitative easing, known as QE2
Brazil and Chile, among the most affected countries, have undertaken actions to protect their economies
Why the harsh reaction, when most people in the United States view QE2 as a purely domestic policy designed to reboot a faltering economic recovery?
“This is a currency war that is turning into a trade war.”
—Guido MantegaFinance Minister of Brazil
Photo source: Agencia Brasil, http://commons.wikimedia.org/wiki/File:Guido_mantega.jpg
Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com
Making Waves
Fact No. 1: There is no such thing as purely domestic monetary policy in today’s world
Central bank actions of even the smallest countries create ripples in the global financial system
The Fed’s actions can create bigger wavesPhoto source: Malene Thyssen, http://commons.wikimedia.org/wiki/User:Malene
Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com
How QE2 Affects the Global Economy
The Fed’s purchases of longer-term Treasury securities under QE2 tend to reduce yields on those securities
Paying for the purchases increases bank reserves, putting additional downward pressure on US interest rates
When US interest rates fall, some investors look for better opportunities abroad
Countries like Brazil, Chile, and others experience increased financial inflows
The Federal Reserve Building in Washington, D.C.Photo source: AgnosticPreachersKid, http://commons.wikimedia.org/wiki/File:Marriner_S._Eccles_Federal_Reserve_Board_Building.jpg
Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com
The Impossible Trinity
According to the “impossible trinity,” a country can choose only two of the following three:
An independent monetary policy
An open capital account A fixed exchange rate
Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com
Effects of Financial Inflows: Variant 1
If a country chooses an independent monetary policy and an open capital account, it must have a floating exchange rate
An increase in financial inflows will cause its exchange rate to appreciate
Consumers and other buyers of imported goods will benefit, but exporters and manufacturers that compete with imports will suffer
If the political influence of exporters and import-competitors is disproportionately great, as is often the case, then the political reaction to currency appreciation will be mostly negative
Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com
Effects of Financial Inflows: Variant 2
If a country chooses a fixed exchange rate and an open capital account, it loses independent control of monetary policy
When financial inflows increase, the central bank must buy foreign currency in order to prevent exchange-rate appreciation
It pays for the foreign currency with newly created domestic money
The increased money supply causes inflation, which, in turn, undercuts the competitiveness of exports
This combination of a fixed nominal exchange rate plus inflation can also be described as real appreciation of the country’s currency
Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com
Effects of Financial Inflows: Variant 3
A country can maintain fixed exchange rate and use its monetary policy independently to control inflation if it closes the capital account and blocks unwanted financial inflows
Orthodox economics has tended to frown on this option because cutting off financial inflows can deprive the economy of a vital source of capital
In that case, stability of the exchange rate and the price level comes at the expense of slow economic growth
Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com
Compromise policy: Partial capital controls
Some countries, including Brazil and Chile, have tried a compromise policy that partly restricts financial inflows without completely closing the capital account
The idea is to filter out unwanted, short-term, speculative “hot money” while allowing inflows of growth-promoting, long-run direct foreign investment
These controls may help in the short run, but they may lose their effectiveness over time
Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com
Compromise policy: Sterilization
Another possible compromise, currently being used by Chile, is to “sterilize” foreign exchange market intervention
A central bank is said to sterilize when it buys foreign currency to resist appreciation, and then neutralizes the monetary effects by selling bonds or other non-monetary financial instruments
However, sterilization can be very expensive and may not work well for more than short periods
Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com
Why South America Hates QE2
The impossible trinity makes it easier to see why South American finance ministers and central bankers do not like QE2
QE2 causes increased financial inflows, which cause unwanted inflation and exchange rate appreciation
Countermeasures can be taken, but because of the impossible trinity, all countermeasures involve costs and compromises
Photo source: NASA, http://commons.wikimedia.org/wiki/File:South_America_satellite_plane.jpg
Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com
But QE2 is Only Part of the Problem
However, QE2 is only one among many sources of Latin America’s problems
As this chart shows, the trend toward real exchange rate appreciation was underway long before QE2
Other causes of currency appreciation in Latin America: Dynamic, well-managed economies that
offer many investment opportunities Increases in world commodity prices
during recovery from the global financial crisis
Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com
The Bottom Line: Ripples, but not a Tsunami
The bottom line: QE2 may make life a little harder for Latin
American policy makers, but they have other problems as well
QE2 is making ripples in the world financial system, but hardly a tsunami
QE2 is not the start of a global currency war; It is a domestic program with moderate but unavoidable external effects
In the long run, if QE2 works to speed recovery, US trading partners everywhere will benefit