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Monetary Policy Challenges in Emerging Markets: Sudden Stop, Liability Dollarization, and Lender of Last Resort

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  • 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) are likely fall short of providing a satisfactory guide for monetary policy in EMs.

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Bibliographic Info

Paper provided by Inter-American Development Bank, Research Department in its series Research Department Publications with number 4504.

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Date of creation: Dec 2006
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Handle: RePEc:idb:wpaper:4504

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  1. Obstfeld, Maurice, 1996. "Models of Currency Crises with Self-fulfilling Features," CEPR Discussion Papers 1315, C.E.P.R. Discussion Papers.
  2. Guillermo A. Calvo, 1996. "Capital flows and macroeconomic management: tequila lessons," Working Papers in Applied Economic Theory 96-02, Federal Reserve Bank of San Francisco.
  3. Valerie Cerra & Sweta C. Saxena, 2005. "Growth Dynamics: The Myth of Economic Recovery," Macroeconomics 0508008, EconWPA.
  4. Guillermo A. Calvo & Carmen M. Reinhart, 2000. "Fear of Floating," NBER Working Papers 7993, National Bureau of Economic Research, Inc.
  5. Woodford, Michael, 2001. "Fiscal Requirements for Price Stability," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(3), pages 669-728, August.
  6. Guillermo A. Calvo & Alejandro Izquierdo & Luis Fernando Mejía, 2004. "On the Empirics of Sudden Stops: The Relevance of Balance-Sheet Effects," Research Department Publications 4367, Inter-American Development Bank, Research Department.
  7. Guillermo A. Calvo & Carlos A. Vegh, 1999. "Inflation Stabilization and BOP Crises in Developing Countries," NBER Working Papers 6925, National Bureau of Economic Research, Inc.
  8. Ariel Burstein & Martin Eichenbaum & Sergio Rebelo, 2005. "Modeling Exchange Rate Passthrough After Large Devaluations," RCER Working Papers 514, University of Rochester - Center for Economic Research (RCER).
  9. Guillermo A. Calvo, 2005. "Emerging Capital Markets in Turmoil: Bad Luck or Bad Policy?," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262033348, December.
  10. Calvo, Guillermo A & Vegh, Carlos A, 1995. "Fighting Inflation with High Interest Rates: The Small Open Economy Case under Flexible Prices," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(1), pages 49-66, February.
  11. Guillermo A. Calvo & Carmen M. Reinhart, 2000. "Fixing for Your Life," NBER Working Papers 8006, National Bureau of Economic Research, Inc.
  12. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  13. Sweta Chaman Saxena & Valerie Cerra, 2005. "Growth Dynamics," IMF Working Papers 05/147, International Monetary Fund.
  14. Luis Felipe Céspedes & Roberto Chang & Andrés Velasco, 2002. "Dollarization of Liabilities, Net Worth Effects, and Optimal Monetary Policy," NBER Chapters, in: Preventing Currency Crises in Emerging Markets, pages 559-600 National Bureau of Economic Research, Inc.
  15. Ricardo J. Caballero & Arvind Krishnamurthy, 2004. "Inflation Targeting and Sudden Stops," NBER Chapters, in: The Inflation-Targeting Debate, pages 423-446 National Bureau of Economic Research, Inc.
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