Working Paper: NBER ID: w12788
Authors: Guillermo A. Calvo
Abstract: The paper argues that Emerging Market economies (EMs) face financial vulnerabilities that weaken the effectiveness of a domestic Lender of Last Resort (LOLR). As a result, monetary policy is inextricably linked to the state of the credit market. In particular, the central bank should be ready to operate as LOLR during Sudden Stop (of capital inflows) by releasing international reserves in an effective manner. These conditions also impact on optimal monetary policy in normal but high-volatility periods. The paper further argues that during those periods interest rate rules may engender excessive volatility of exchange rates and, thus, that it may be advisable to temporarily supplement those rules by foreign exchange market intervention or outright exchange rate pegging. At a fundamental level, the analysis suggests that the state-of-the-art literature summarized by Woodford (2003) or even more heterodox approaches exemplified by Stiglitz and Greenwald (2003) likely fall short of providing a satisfactory guide for monetary policy in EMs.
Keywords: Emerging Markets; Monetary Policy; Lender of Last Resort; Liability Dollarization
JEL Codes: E52; E58; F32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Financial vulnerabilities (F65) | Effectiveness of domestic lender of last resort (LOLR) (E58) |
| Sudden stops in capital inflows (F32) | Central bank's ability to provide liquidity (E58) |
| Central bank's ability to provide liquidity (E58) | Long-term growth prospects (D25) |
| Interest rate rules (E43) | Excessive volatility in exchange rates (F31) |
| Monetary policy decisions (E52) | Exchange rate stability (F31) |