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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. Holmstrom, B & Tirole, J, 1996. "Private and Public Supply of Liquidity," Working papers 96-21, Massachusetts Institute of Technology (MIT), Department of Economics.
  3. Nicolas Magud & Carmen M. Reinhart, 2005. "Capital Controls: An Evaluation," University of Oregon Economics Department Working Papers 2005-19, University of Oregon Economics Department.
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  4. 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.
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  7. 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.
  8. Bulow, Jeremy & Rogoff, Kenneth, 1989. "A Constant Recontracting Model of Sovereign Debt," Journal of Political Economy, University of Chicago Press, vol. 97(1), pages 155-78, February.
  9. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, December.
  10. Reinhart, Carmen & Calvo, Guillermo & Leiderman, Leonardo, 1993. "Af1uencia de capital y apreciacion del tipo de cambio real en America Latina: E1 papel de los factores externos
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  11. Douglas W. Diamond, 1991. "Debt Maturity Structure and Liquidity Risk," The Quarterly Journal of Economics, Oxford University Press, vol. 106(3), pages 709-737.
  12. Kang, Jun-Koo & Stulz, Rene M., 1997. "Why is there a home bias? An analysis of foreign portfolio equity ownership in Japan," Journal of Financial Economics, Elsevier, vol. 46(1), pages 3-28, October.
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  14. Guillermo A. Calvo, 1991. "The Perils of Sterilization," IMF Staff Papers, Palgrave Macmillan, vol. 38(4), pages 921-926, December.
  15. Leonardo Leiderman & Carmen Reinhart & Guillermo Calvo, 1992. "Capital Inflows and Real Exchange Rate Appreciation in Latin America; The Role of External Factors," IMF Working Papers 92/62, International Monetary Fund.
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