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On the Transmission Mechanism of Monetary Constraints to the Real Side of the Economy

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  • Alex Luiz Ferreira

Abstract

Contrary to the predictions of the theory underlying international finance, inflows of capital triggered by financial liberalisation have neither equalised real interest rates nor increased income growth in many emerging economies. We explain this puzzle by developing a model that combines the balance-of-payments constraint approach to economic growth with a less stringent version of the real interest rate parity hypothesis. The model's foundations are based on robust empirical findings or well-established macroeconomic models. We show that a perverse combination of income elasticities of demand for imports and exports generates slow income growth and high real interest rates. As domestic income grows and imports rise faster than exports, the real exchange rate is expected to depreciate in order to clear the balance of payments (or the foreign exchange rate market). An incipient capital outflow arises and interest rates increase. Faster adjustment in capital rather than in the goods market therefore generates a higher real interest rate differential between the domestic small open-economy and the rest of the world. The long run analysis shows that a constant degree of risk aversion implies a positive equilibrium real interest rate differential that affects economic growth. A permanent increase in default risk driven by persistent current account imbalances thus impacts on long run growth. The model's results are illustrated with evidence from the three major Latin America economies: Argentina, Brazil and Mexico.

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Bibliographic Info

Article provided by Taylor & Francis Journals in its journal International Review of Applied Economics.

Volume (Year): 21 (2007)
Issue (Month): 1 ()
Pages: 43-54

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Handle: RePEc:taf:irapec:v:21:y:2007:i:1:p:43-54

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Keywords: Real interest rate differentials; balance of payments constraint;

References

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  1. Kevin Nell, 2003. "A 'Generalised' Version of the Balance-of-Payments Growth Model: An application to neighbouring regions," International Review of Applied Economics, Taylor & Francis Journals, Taylor & Francis Journals, vol. 17(3), pages 249-267.
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  3. Sebastian Edwards, 1985. "The Pricing of Bonds and Bank Loans in International Markets: An Empirical Analysis of Developing Countries' Foreign Borrowing," NBER Working Papers 1689, National Bureau of Economic Research, Inc.
  4. Martin Uribe & Vivian Yue, 2004. "Country spreads and emerging countries: who drives whom?," Proceedings, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco, issue Jun.
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  7. Barry Eichengreen & Ashoka Mody, 2000. "What Explains Changing Spreads on Emerging Market Debt?," NBER Chapters, in: Capital Flows and the Emerging Economies: Theory, Evidence, and Controversies, pages 107-134 National Bureau of Economic Research, Inc.
  8. Anthony Philip Thirlwall, 1979. "The Balance of Payments Constraint as an Explanation of International Growth Rate Differences," BNL Quarterly Review, Banca Nazionale del Lavoro, Banca Nazionale del Lavoro, vol. 32(128), pages 45-53.
  9. Thirlwall, Anthony P & Hussain, Mohammed Nureldin, 1982. "The Balance of Payments Constraint, Capital Flows and Growth Rate Differences between Developing Countries," Oxford Economic Papers, Oxford University Press, vol. 34(3), pages 498-510, November.
  10. Vivian Z. Yue & Samir Jahjah, 2004. "Exchange Rate Policy and Sovereign Bond Spreads in Developing Countries," IMF Working Papers 04/210, International Monetary Fund.
  11. Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, Elsevier, vol. 3(2), pages 123-192, June.
  12. Dawn Richards Elliott & Rupert Rhodd, 1999. "Explaining growth rate differences in highly indebted countries: an extension to Thirlwall and Hussain," Applied Economics, Taylor & Francis Journals, Taylor & Francis Journals, vol. 31(9), pages 1145-1148.
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Cited by:
  1. Alex Luiz Ferreira, 2011. "Monetary Policy,Fundamentals and Risk in Brazil," Anais do XXXVII Encontro Nacional de Economia [Proceedings of the 37th Brazilian Economics Meeting], ANPEC - Associação Nacional dos Centros de Pósgraduação em Economia [Brazilian Association of 55, ANPEC - Associação Nacional dos Centros de Pósgraduação em Economia [Brazilian Association of Graduate Programs in Economics].

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