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Sterilization costs and exchange rate targeting

  • Kenneth Kletzer
  • Mark Spiegel

This paper examines the movements of exchange rates and capital flows in an environment where an optimizing central bank pursuing the joint goals of inflation and output targeting engages in costly sterilization activities. Our results predict that when faced with increased sterilization costs, the central bank will choose to limit its sterilization activities allowing target variables, such as the nominal exchange rate, to adjust. ; We then test the predictions of a linearized version of the saddle-path solution to the model for a cross-country panel of developing countries. We use IV, GMM and simultaneous equation specifications to allow for the endogeneity of capital inflows. Our results confirm that a monetary policy does respond to sterilization costs.

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Paper provided by Federal Reserve Bank of San Francisco in its series Pacific Basin Working Paper Series with number 99-03.

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Date of creation: 1999
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Handle: RePEc:fip:fedfpb:99-03
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  1. Dekle, Robert & Kletzer, Kenneth, 2003. "The Japanese Banking Crisis and Economic Growth: Theoretical and Empirical Implications of Deposit Guarantees and Weak Financial Regulation," Santa Cruz Department of Economics, Working Paper Series qt0t6321ds, Department of Economics, UC Santa Cruz.
  2. Reinhart, Carmen & Calvo, Guillermo & Leiderman, Leonardo, 1996. "Inflows of capital to developing countries in the 1990s," MPRA Paper 13707, University Library of Munich, Germany.
  3. Frankel, Jeffrey A & Okongwu, Chudozie, 1996. "Liberalized Portfolio Capital Inflows in Emerging Markets: Sterilization, Expectations, and the Incompleteness of Interest Rate Convergence," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 1(1), pages 1-23, January.
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  6. Holtz-Eakin, Douglas & Newey, Whitney & Rosen, Harvey S, 1988. "Estimating Vector Autoregressions with Panel Data," Econometrica, Econometric Society, vol. 56(6), pages 1371-95, November.
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  8. Flood, Robert P & Garber, Peter M, 1984. "Gold Monetization and Gold Discipline," Journal of Political Economy, University of Chicago Press, vol. 92(1), pages 90-107, February.
  9. Daniels, Joseph, 1997. "Optimal sterilization policies in interdependent economies," Journal of Economics and Business, Elsevier, vol. 49(1), pages 43-60, February.
  10. Carmen M. Reinhart & R. Todd Smith, 1996. "Too much of a good thing: the macroeconomic effects of taxing capital inflows," Proceedings, Federal Reserve Bank of San Francisco, pages 436-464.
  11. Craig Burnside & Martin Eichenbaum & Sergio Rebelo, 1998. "Prospective deficits and the Asian currency crisis," Working Paper Series WP-98-5, Federal Reserve Bank of Chicago.
  12. Krugman, Paul, 1979. "A Model of Balance-of-Payments Crises," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 11(3), pages 311-25, August.
  13. Obstfeld, Maurice, 1986. "Rational and Self-fulfilling Balance-of-Payments Crises," American Economic Review, American Economic Association, vol. 76(1), pages 72-81, March.
  14. Willem H. Buiter, 1986. "Borrowing to Defend the Exchange Rate and the Timing and Magnitude of Speculative Attacks," NBER Working Papers 1844, National Bureau of Economic Research, Inc.
  15. Guillermo A. Calvo & Leonardo Leiderman & Carmen M. Reinhart, 1993. "Capital Inflows and Real Exchange Rate Appreciation in Latin America: The Role of External Factors," IMF Staff Papers, Palgrave Macmillan, vol. 40(1), pages 108-151, March.
  16. Dooley, Michael P, 2000. "A Model of Crises in Emerging Markets," Economic Journal, Royal Economic Society, vol. 110(460), pages 256-72, January.
  17. Arellano, Manuel & Bover, Olympia, 1995. "Another look at the instrumental variable estimation of error-components models," Journal of Econometrics, Elsevier, vol. 68(1), pages 29-51, July.
  18. Blundell, R. & Bond, S., 1995. "Initial Conditions and Moment Restrictions in Dynamic Panel Data Models," Economics Papers 104, Economics Group, Nuffield College, University of Oxford.
  19. Mark M. Spiegel, 1995. "Sterilization of capital inflows through the banking sector: evidence from Asia," Pacific Basin Working Paper Series 95-06, Federal Reserve Bank of San Francisco.
  20. Kenneth Kletzer & Mark Spiegel, 1996. "Speculative capital inflows and exchange rate targeting in the Pacific Basin," Pacific Basin Working Paper Series 96-05, Federal Reserve Bank of San Francisco.
  21. Guillermo A. Calvo, 1991. "The Perils of Sterilization," IMF Staff Papers, Palgrave Macmillan, vol. 38(4), pages 921-926, December.
  22. Arellano, Manuel & Bond, Stephen, 1991. "Some Tests of Specification for Panel Data: Monte Carlo Evidence and an Application to Employment Equations," Review of Economic Studies, Wiley Blackwell, vol. 58(2), pages 277-97, April.
  23. Nouriel Roubini, 1988. "Offset and Sterilization Under Fixed Exchange Rates With An Optimizing Central Bank," NBER Working Papers 2777, National Bureau of Economic Research, Inc.
  24. Reinhart, Carmen & Khan, Mohsin, 1995. "Macroeconomic Management in APEC Economies: The Response to Capital Inflows," MPRA Paper 8148, University Library of Munich, Germany.
  25. Flood, Robert P. & Garber, Peter M., 1984. "Collapsing exchange-rate regimes : Some linear examples," Journal of International Economics, Elsevier, vol. 17(1-2), pages 1-13, August.
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