1. More Slides from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ The Impossible Trinity, or, Why Latin America Hates QE2 Posted January 19, 2011 http://dolanecon.blogspot.com/ Terms of Use: These slides are made available under Creative Commons License Attribution— Share Alike 3.0. You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishers.Attribution— Share Alike 3.0 Introduction to Economics

2. Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com http://dolanecon.blogspot.com Latin America Up in Arms over QE2  Latin America is up in arms over the Fed’s program of quantitative easing, known as QE2  Brazil and Chile, among the most affected countries, have undertaken actions to protect their economies  Why the harsh reaction, when most people in the United States view QE2 as a purely domestic policy designed to reboot a faltering economic recovery? “This is a currency war that is turning into a trade war.” —Guido Mantega Finance Minister of Brazil Photo source: Agencia Brasil, http://commons.wikimedia.org/wiki/File:Guido_mantega.jpg

3. Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com http://dolanecon.blogspot.com Making Waves  Fact No. 1: There is no such thing as purely domestic monetary policy in today’s world  Central bank actions of even the smallest countries create ripples in the global financial system  The Fed’s actions can create bigger waves Photo source: Malene Thyssen, http://commons.wikimedia.org/wiki/User:Malene http://commons.wikimedia.org/wiki/User:Malene

4. Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com http://dolanecon.blogspot.com How QE2 Affects the Global Economy  The Fed’s purchases of longer-term Treasury securities under QE2 tend to reduce yields on those securities  Paying for the purchases increases bank reserves, putting additional downward pressure on US interest rates  When US interest rates fall, some investors look for better opportunities abroad  Countries like Brazil, Chile, and others experience increased financial inflows The Federal Reserve Building in Washington, D.C. Photo source: AgnosticPreachersKid, http://commons.wikimedia.org/wiki/File:Marriner_S._Eccles_Federal_Reserve _Board_Building.jpg

5. Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com http://dolanecon.blogspot.com The Impossible Trinity According to the “impossible trinity,” a country can choose only two of the following three:  An independent monetary policy  An open capital account  A fixed exchange rate

6. Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com http://dolanecon.blogspot.com Effects of Financial Inflows: Variant 1  If a country chooses an independent monetary policy and an open capital account, it must have a floating exchange rate  An increase in financial inflows will cause its exchange rate to appreciate  Consumers and other buyers of imported goods will benefit, but exporters and manufacturers that compete with imports will suffer  If the political influence of exporters and import- competitors is disproportionately great, as is often the case, then the political reaction to currency appreciation will be mostly negative

7. Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com http://dolanecon.blogspot.com Effects of Financial Inflows: Variant 2  If a country chooses a fixed exchange rate and an open capital account, it loses independent control of monetary policy  When financial inflows increase, the central bank must buy foreign currency in order to prevent exchange-rate appreciation  It pays for the foreign currency with newly created domestic money  The increased money supply causes inflation, which, in turn, undercuts the competitiveness of exports  This combination of a fixed nominal exchange rate plus inflation can also be described as real appreciation of the country’s currency

8. Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com http://dolanecon.blogspot.com Effects of Financial Inflows: Variant 3  A country can maintain fixed exchange rate and use its monetary policy independently to control inflation if it closes the capital account and blocks unwanted financial inflows  Orthodox economics has tended to frown on this option because cutting off financial inflows can deprive the economy of a vital source of capital  In that case, stability of the exchange rate and the price level comes at the expense of slow economic growth

9. Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com http://dolanecon.blogspot.com Compromise policy: Partial capital controls  Some countries, including Brazil and Chile, have tried a compromise policy that partly restricts financial inflows without completely closing the capital account  The idea is to filter out unwanted, short-term, speculative “hot money” while allowing inflows of growth-promoting, long-run direct foreign investment  These controls may help in the short run, but they may lose their effectiveness over time

10. Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com http://dolanecon.blogspot.com Compromise policy: Sterilization  Another possible compromise, currently being used by Chile, is to “sterilize” foreign exchange market intervention  A central bank is said to sterilize when it buys foreign currency to resist appreciation, and then neutralizes the monetary effects by selling bonds or other non-monetary financial instruments  However, sterilization can be very expensive and may not work well for more than short periods

11. Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com http://dolanecon.blogspot.com Why South America Hates QE2  The impossible trinity makes it easier to see why South American finance ministers and central bankers do not like QE2  QE2 causes increased financial inflows, which cause unwanted inflation and exchange rate appreciation  Countermeasures can be taken, but because of the impossible trinity, all countermeasures involve costs and compromises Photo source: NASA, http://commons.wikimedia.org/wiki/File:South_America_satellite_pl ane.jpg

12. Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com http://dolanecon.blogspot.com But QE2 is Only Part of the Problem  However, QE2 is only one among many sources of Latin America’s problems  As this chart shows, the trend toward real exchange rate appreciation was underway long before QE2  Other causes of currency appreciation in Latin America:  Dynamic, well-managed economies that offer many investment opportunities  Increases in world commodity prices during recovery from the global financial crisis

13. Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com http://dolanecon.blogspot.com The Bottom Line: Ripples, but not a Tsunami The bottom line:  QE2 may make life a little harder for Latin American policy makers, but they have other problems as well  QE2 is making ripples in the world financial system, but hardly a tsunami  QE2 is not the start of a global currency war; It is a domestic program with moderate but unavoidable external effects  In the long run, if QE2 works to speed recovery, US trading partners everywhere will benefit