Olivier Blanchard writes:

Olivier Blanchard: Monetary Policy Will Never Be the Same:

Finally, turning to capital flows. In emerging markets (and, more generally, in small advanced economies, although these were not explicitly covered at the conference), the evidence suggests the best way to deal with volatile capital flows is by letting the exchange rate absorb most but not necessarily all the adjustment.

The standard argument in favor of letting the exchange rate adjust was stated by Paul Krugman at the conference. If investors want to take their funds out, let them: the exchange rate will depreciate, and this will lead, if anything, to an increase in exports and an increase in output.

Three arguments have traditionally been given, however, against relying on exchange rate adjustment. The first is that, to the extent that domestic borrowers have borrowed in foreign currency, the depreciation has adverse effects on balance sheets, and leads to a decrease in domestic demand that may more than offset the increase in exports. The second is that much of the nominal depreciation may simply translate into higher inflation. The third is that large movements in the exchange rate may lead to disruptions, both in the real economy and in financial markets.

The evidence, however, is that the first two are much less relevant than they were in previous crises… foreign exchange exposure in emerging market countries is much more limited than it was in previous crises. And thanks to increased credibility of monetary policy and inflation targets, inflation expectations appear much better anchored, leading to limited effects of exchange rate movements on inflation.

However the third argument remains relevant. And this is why central banks in emerging market countries have not moved to full float, but to managed float, that is the joint use of the policy rate, foreign exchange intervention, macroprudential measures, and capital controls…

I always thought that the three arguments for why a country facing capital flight should not simply let the currency fall in value until speculators thought its next bounce was likely to be up were different. I got the first argument that if your economy has lots of hard currency foreign debt, reducing the value of your currency produces not boom but depression because whatever boost to exports you get is vastly outweighed by the crash in consumption and investment spending produced by universal bankruptcy. I got the second argument that if your domestic price level was tightly geared to import prices even a small real depreciation might require a very large nominal inflation, and the cost of that nominal inflation might make the policy of depreciation unwise. Those seemed to me to be legitimate cases in which you might have to grin and bear it, and respond to capital flight by raising domestic interest rates and so defend the value of your currency by attacking the economy and causing a depression.

And I thought there was a third argument: that you were tied in some form of currency union for larger political reasons, and that the maintenance of some international public good required a currency peg. But in that case it seemed to me that dealing with capital flight was then at least as much the problem of the potential surplus countries as of the deficit country, and it formulating the problem as how the deficit country adjusts was profoundly unhelpful.

But Olivier’s third case is different from mine. It is:

large movements in the exchange rate may lead to disruptions, both in the real economy and in financial markets…

Yes, large movements of the exchange rate lead to disruptions. But large movements in interest rates needed to keep losses in confidence from producing large movements in exchange rates also lead to disruptions. And if you seek to avoid both exchange-rate and interest-rate movements, the financial repression and capital controls needed also lead to disruptions.

Thus when I hear “large movements in exchange rates may lead to disruptions” I think that what it means is: “there is reason to think that importers have higher marginal utility then do exporters or consumers or investors or asset holders”. And it is not obvious to me why this should be the case

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