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International Liquidity Management: Sterilization Policy in Illiquid Financial Markets

  • Ricardo J. Caballero

    (Massachusetts Institute of Technology)

  • Arvind Krishnamurthy

    (Northwestern University)

During the booms that invariably precede crises in emerging economies, policy makers often struggle to limit capital flows and their expansionary consequences. The main policy tool for this task is sterilization --essentially a swap of international reserves for public bonds. However, there is an extensive debate on the effectiveness of this policy, with many arguing that it may be counterproductive once the (over-) reaction of the private sector is considered. But what forces account for the private sector's reaction remains largely unexplained. In this paper we provide a model to discuss these issues. We first demonstrate that policies to smooth expansions in anticipation of downturns can be Pareto improving in economies where domestic financial markets are underdeveloped. We then discuss the implementation of this policy via sterilization, outlining cases in which the policy succeeds and those in which it fails. Paradoxically the greatest risk of policy arises in situations where policy is most needed -- that is when financial markets are illiquid. Our mechanism is akin to the ``implicit bailout" problem, despite the fact that the central bank acts non-selectively and only intervenes through open markets; illiquidity replaces corruption and ineptitude. In addition to an appreciation of the currency and the emergence of a quasi-fiscal deficit, the private sector's reaction to sterilization may lead to an expansion rather than the wanted contraction in aggregate demand and a bias toward short term capital inflows.

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Paper provided by Econometric Society in its series Econometric Society World Congress 2000 Contributed Papers with number 1700.

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Date of creation: 01 Aug 2000
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Handle: RePEc:ecm:wc2000:1700
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  1. John Moore & Nobuhiro Kiyotaki, . "Credit Cycles," Discussion Papers 1995-5, Edinburgh School of Economics, University of Edinburgh.
  2. Jeffrey A. Frankel, 1997. "Sterilization of money inflows: Difficult (Calvo) or Easy (Reisen)?," Estudios de Economia, University of Chile, Department of Economics, vol. 24(2 Year 19), pages 263-285, December.
  3. Jeremy I. Bulow & Kenneth Rogoff, 1987. "A Constant Recontracting Model of Sovereign Debt," NBER Working Papers 2088, National Bureau of Economic Research, Inc.
  4. Reinhart, Carmen & Magud, Nicolas, 2007. "Capital controls: An evaluation," MPRA Paper 14097, University Library of Munich, Germany.
    • Nicolas Magud & Carmen M. Reinhart, 2007. "Capital Controls: An Evaluation," NBER Chapters, in: Capital Controls and Capital Flows in Emerging Economies: Policies, Practices and Consequences, pages 645-674 National Bureau of Economic Research, Inc.
  5. Jun-Koo Kang & Rene M. Stulz, 1995. "Why Is There a Home Bias? An Analysis of Foreign Portfolio Equity Ownership in Japan," NBER Working Papers 5166, National Bureau of Economic Research, Inc.
  6. Guillermo A. Calvo, 1991. "The Perils of Sterilization," IMF Staff Papers, Palgrave Macmillan, vol. 38(4), pages 921-926, December.
  7. Diamond, Douglas W, 1991. "Debt Maturity Structure and Liquidity Risk," The Quarterly Journal of Economics, MIT Press, vol. 106(3), pages 709-37, August.
  8. Montiel, Peter & Reinhart, Carmen M., 1999. "Do capital controls and macroeconomic policies influence the volume and composition of capital flows? Evidence from the 1990s," Journal of International Money and Finance, Elsevier, vol. 18(4), pages 619-635, August.
  9. Allen, F. & Gale, D., 1991. "Limited Market Participation and Volatility of Asset Prices," Weiss Center Working Papers 2-92, Wharton School - Weiss Center for International Financial Research.
  10. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, June.
  11. Bengt Holmstrom & Jean Tirole, 1998. "Private and Public Supply of Liquidity," Journal of Political Economy, University of Chicago Press, vol. 106(1), pages 1-40, February.
  12. Reinhart, Carmen & Reinhart, Vincent, 1998. "“Some Lessons for Policy Makers Who Deal with the Mixed Blessing of Capital Inflows,”," MPRA Paper 7123, University Library of Munich, Germany.
  13. Reinhart, Carmen & Calvo, Guillermo & Leiderman, Leonardo, 1993. "“Capital Inflows and Real Exchange Rate Appreciation in Latin America: The Role of External Factors," MPRA Paper 7125, University Library of Munich, Germany.
  14. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Wiley Blackwell, vol. 48(2), pages 289-309, April.
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