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International Liquidity Management: Sterilization Policy in Illiquid Financial Markets

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  • Ricardo J. Caballero

    (Massachusetts Institute of Technology)

  • Arvind Krishnamurthy

    (Northwestern University)

Abstract

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.

Suggested Citation

  • Ricardo J. Caballero & Arvind Krishnamurthy, 2000. "International Liquidity Management: Sterilization Policy in Illiquid Financial Markets," Econometric Society World Congress 2000 Contributed Papers 1700, Econometric Society.
  • Handle: RePEc:ecm:wc2000:1700
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    Cited by:

    1. Ricardo J.Caballero, 2001. "Macroeconomic volatility in Latin America: a view and three case studies," Estudios de Economia, University of Chile, Department of Economics, vol. 28(1 Year 20), pages 5-52, June.
    2. Douglas W. Diamond & Raghuram G. Rajan, 2005. "Liquidity Shortages and Banking Crises," Journal of Finance, American Finance Association, vol. 60(2), pages 615-647, April.
    3. Caballero, Ricardo J. & Krishnamurthy, Arvind, 2004. "Smoothing sudden stops," Journal of Economic Theory, Elsevier, vol. 119(1), pages 104-127, November.
    4. Caballero, Ricardo J. & Krishnamurthy, Arvind, 2001. "International and domestic collateral constraints in a model of emerging market crises," Journal of Monetary Economics, Elsevier, vol. 48(3), pages 513-548, December.
    5. M S Mohanty & Philip Turner, 2005. "Intervention: what are the domestic consequences?," BIS Papers chapters,in: Bank for International Settlements (ed.), Foreign exchange market intervention in emerging markets: motives, techniques and implications, volume 24, pages 56-81 Bank for International Settlements.
    6. Ricardo J. Caballero & Arvind Krishnamurthy, 2000. "Dollarization of Liabilities: Underinsurance and Domestic Financial Underdevelopment," NBER Working Papers 7792, National Bureau of Economic Research, Inc.
    7. Raghuram G. Rajan & Ioannis Tokatlidis, 2005. "Dollar Shortages and Crises," International Journal of Central Banking, International Journal of Central Banking, vol. 1(2), September.
    8. Chiueh, Y. & Chen, M. C., 2003. "An economic analysis of Taiwan water market and water bank establishment," IWMI Books, Reports H033354, International Water Management Institute.
    9. Ricardo Caballero & Arvind Krishnamurthy, 2001. "A "Vertical" Analysis of Crises and Intervention: Fear of Floating and Ex-ante Problems," NBER Working Papers 8428, National Bureau of Economic Research, Inc.
    10. Fernando Aportela & Francisco Gallego & Pablo García, 2003. "Reserves Over the Transitions to Floating and to Inflation Targeting: Lessons From the Developed World," Working Papers Central Bank of Chile 211, Central Bank of Chile.
    11. Ricardo J. Caballero & Arvind Krishnamurthy, 2001. "International Liquidity Illusion: On the Risks of Sterilization," NBER Working Papers 8141, National Bureau of Economic Research, Inc.

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