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


  • Alex Luiz Ferreira


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.

Suggested Citation

  • Alex Luiz Ferreira, 2007. "On the Transmission Mechanism of Monetary Constraints to the Real Side of the Economy," International Review of Applied Economics, Taylor & Francis Journals, vol. 21(1), pages 43-54.
  • Handle: RePEc:taf:irapec:v:21:y:2007:i:1:p:43-54
    DOI: 10.1080/02692170601034994

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    References listed on IDEAS

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    11. 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, vol. 17(3), pages 249-267.
    12. 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.
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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] 55, ANPEC - Associação Nacional dos Centros de Pósgraduação em Economia [Brazilian Association of Graduate Programs in Economics].


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