1234567891011121314151617Models of Balance of Payments Crises with CapitalControlsEmilio Espino, Alfonso Gauna and Andy NeumeyerUniversidad Torcuato Di TellaBCRP-FLAR-NBER Emerging Markets ConferenceLima, 20-21 May 2024IntroductionSetupKrugman equilibriumKrugman with Capital ControlsImport restrictionsFinal RemarksBretton WoodsReferences# 1Printing Money without InflationInconsistent monetary and exchange rate policiesSome countries want to finance deficits by printing money and, to keep inflation low, adopt anunsustainable fixed exchange rate/crawling peg.domestic credit growthθ>εrate of devaluationFree Capital Mobility: low inflation (ε<θ) => speculative attack on the BoP => high inflation(Krugman, 1979).Capital controls are often introduced to delay the collapse of the fixed exchange rate▶Sell FX only to importers to “save” reserves & free trade => CA deficit => collapse.▶Introduce import restrictions to avoid collapse => missallocation: trade autarky.IntroductionSetupKrugman equilibriumKrugman with Capital ControlsImport restrictionsFinal RemarksBretton WoodsReferences# 2Inconsistent monetary and exchange rate policy with capital controlsFree Trade▶Capital controls cannot avoid the collapse of the fixed exchange rate▶The expansionary monetary policy results in current account deficits that drain reserves.▶The regime ends with ananticipated devaluationwhen reserves are zero.▶Unpleasant monetarist arithmetic: delaying monetization by issuing debt anticipates theregime’s collapse.Introduce import restrictions so that∆Reserves = 0 forever.▶Domestic prices are decoupled from PPP at the official exchange rate (≃import quota).▶Wedge between the XR and the local price is an implicit tax on exports.▶As the implicit export tax grows, the economy converges to autarky.▶Consumption falls over time andreal interest rates are below international ones.▶Pleasant monetarist arithmetic. Delaying monetization reduces inflation.IntroductionSetupKrugman equilibriumKrugman with Capital ControlsImport restrictionsFinal RemarksBretton WoodsReferences# 3Incidence of Multiple Exchange Rate Arrangements, 1950–2001Simplified IMF ClassificationSource: Reinhart and Rogoff (2004)26 countries have multiple exchange rates todayIntroductionSetupKrugman equilibriumKrugman with Capital ControlsImport restrictionsFinal RemarksBretton WoodsReferences# 4Afghanistan19501960197019801990200010-210-1100101102Afghanis per dollar00.511.522.533.54log(Black Market/Official)OfficialBlack MarketPremiumSource:Ilzetzki, Ethan, Carmen M. Reinhart and Kenneth Rogoff (2019)IntroductionSetupKrugman equilibriumKrugman with Capital ControlsImport restrictionsFinal RemarksBretton WoodsReferences# 5Perú1950195519601965197019751980198519901995100101102Soles per dollar-0.200.20.40.60.81log(Black Market/Official)OfficialBlack MarketPremiumSource:Ilzetzki, Ethan, Carmen M. Reinhart and Kenneth Rogoff (2019)IntroductionSetupKrugman equilibriumKrugman with Capital ControlsImport restrictionsFinal RemarksBretton WoodsReferences# 6Capital Controls, Inflation, and GrowthA Comparison of Dual (or Multiple) and Unified Exchange Rate Systems 1970–2001RegimeAverage annual Average per capitainflation rate real GDP growthUnified Exchange Rate 19.8 1.8Dual (or multiple) exchange rates 162.5 0.8Source: Reinhart and Rogoff (2004)Barro-Lee (1994), Sources of Economic Growth.Per capita GDP growth=−0.028 lnParallel XROfficial XR+XβA one-standard-deviation increase in the BMP variable (0.2) reduces the growth rate by 0.6percentage points per year.IntroductionSetupKrugman equilibriumKrugman with Capital ControlsImport restrictionsFinal RemarksBretton WoodsReferences# 7Roadmap1.Modelling capital controls and dual exchange rates2.A Model of Capital Controls with Free Trade✱The private sector’s budget constraint with anticipated devaluations✱Optimal behavior with anticipated devaluations✱Characterization of equilibrium3.A Model of Capital Controls with Import Restrictions✱Introduce production and two sectors:TandH✱Budget constraints and implicit taxes✱Characterization of equilibriumIntroductionSetupKrugman equilibriumKrugman with Capital ControlsImport restrictionsFinal RemarksBretton WoodsReferences# 8Modelling capital controls and dual exchange ratesStart with the balance of payments identity∆Reservest+∆Private Net Foreign Assetst≡Current AccounttTypically, capital controls▶force all current account transactions to go through the central bank (at the officialexchange rates), and▶forbid access to foreign exchange from the central bank at the official exchange rate forprivate foreign asset accumulationIn other words,∆Reservest=Current Accountt∆Private Net Foreign Assetst=0Private agents can (legally or illegally) exchange foreign assets for domestic currency amongthemselves at a mutually arranged price.Monetary approach to the BoP:CAt=∆Reservest=∆mt−∆dtIntroductionSetupKrugman equilibriumKrugman with Capital ControlsImport restrictionsFinal RemarksBretton WoodsReferences# 9Shadow exchange rateConsider a Lucas (1978) tree with a dividend equal to the international interest rate,r.Offshore price1Onshore priceQt)Ratio = shadow exchange rate:QtThe tree’s dividend is a perishable consumption goodThe parallel market premium isqt≡Qt/Et.It could be thought as the price of the tree in terms of the fruit.Click for real world example:Stocks;Crypto.IntroductionSetupKrugman equilibriumKrugman with Capital ControlsImport restrictionsFinal RemarksBretton WoodsReferences# 10Onshore interest rates, dual exchange rates, and devaluationNo arbitrage and the domestic return on the foreign currency perpetuityit=rEtQt+Q ̇tQtρt≡i−ε=rqt+q ̇tqtConsider the case in whichEtjumps when the regime changes att=T.AssumeQ(t)is continuous intandQT=E+T≡limδ→0ET+δ.Qt=E+Te−RTti(s)ds+rZTtEse−Rsti(x)dxdsdiscountedQ+PV couponsIntroductionSetupKrugman equilibriumKrugman with Capital ControlsImport restrictionsFinal RemarksBretton WoodsReferences# 11Unsustainable Monetary and Exchange Rate PoliciesConsider a small open economy▶endowment economy▶free tradeP=E▶money in the utility functionLeading case in the literature (Krugman, 1979)▶The rate of growth of central bank credit to the treasury is constant,D ̇t/Dt=θ▶The rate of devaluation is constant,εt=ε<θfort<TWhen the central bank’s international reserves are zero, att=T, the fixed exchangerate regime ends and the exchange rate floats.Link with details on the government ́s budget constraintsIntroductionSetupKrugman equilibriumKrugman with Capital ControlsImport restrictionsFinal RemarksBretton WoodsReferences# 12
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