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Financial Frictions in Macroeconomic Models  

Alfred Duncan and Charles Nolan

In recent decades, macroeconomic researchers have looked to incorporate financial intermediaries explicitly into business-cycle models. These modeling developments have helped us to understand the role of the financial sector in the transmission of policy and external shocks into macroeconomic dynamics. They also have helped us to understand better the consequences of financial instability for the macroeconomy. Large gaps remain in our knowledge of the interactions between the financial sector and macroeconomic outcomes. Specifically, the effects of financial stability and macroprudential policies are not well understood.


International Reserves, Exchange Rates, and Monetary Policy: From the Trilemma to the Quadrilemma  

Joshua Aizenman

The links of international reserves, exchange rates, and monetary policy can be understood through the lens of a modern incarnation of the “impossible trinity” (aka the “trilemma”), based on Mundell and Fleming’s hypothesis that a country may simultaneously choose any two, but not all, of the following three policy goals: monetary independence, exchange rate stability, and financial integration. The original economic trilemma was framed in the 1960s, during the Bretton Woods regime, as a binary choice of two out of the possible three policy goals. However, in the 1990s and 2000s, emerging markets and developing countries found that deeper financial integration comes with growing exposure to financial instability and the increased risk of “sudden stop” of capital inflows and capital flight crises. These crises have been characterized by exchange rate instability triggered by countries’ balance sheet exposure to external hard currency debt—exposures that have propagated banking instabilities and crises. Such events have frequently morphed into deep internal and external debt crises, ending with bailouts of systemic banks and powerful macro players. The resultant domestic debt overhang led to fiscal dominance and a reduction of the scope of monetary policy. With varying lags, these crises induced economic and political changes, in which a growing share of emerging markets and developing countries converged to “in-between” regimes in the trilemma middle range—that is, managed exchange rate flexibility, controlled financial integration, and limited but viable monetary autonomy. Emerging research has validated a modern version of the trilemma: that is, countries face a continuous trilemma trade-off in which a higher trilemma policy goal is “traded off” with a drop in the weighted average of the other two trilemma policy goals. The concerns associated with exposure to financial instability have been addressed by varying configurations of managing public buffers (international reserves, sovereign wealth funds), as well as growing application of macro-prudential measures aimed at inducing systemic players to internalize the impact of their balance sheet exposure on a country’s financial stability. Consequently, the original trilemma has morphed into a quadrilemma, wherein financial stability has been added to the trilemma’s original policy goals. Size does matter, and there is no way for smaller countries to insulate themselves fully from exposure to global cycles and shocks. Yet successful navigation of the open-economy quadrilemma helps in reducing the transmission of external shock to the domestic economy, as well as the costs of domestic shocks. These observations explain the relative resilience of emerging markets—especially in countries with more mature institutions—as they have been buffered by deeper precautionary management of reserves, and greater fiscal and monetary space. We close the discussion noting that the global financial crisis, and the subsequent Eurozone crisis, have shown that no country is immune from exposure to financial instability and from the modern quadrilemma. However, countries with mature institutions, deeper fiscal capabilities, and more fiscal space may substitute the reliance on costly precautionary buffers with bilateral swap lines coordinated among their central banks. While the benefits of such arrangements are clear, they may hinge on the presence and credibility of their fiscal backstop mechanisms, and on curbing the resultant moral hazard. Time will test this credibility, and the degree to which risk-pooling arrangements can be extended to cover the growing share of emerging markets and developing countries.


International Capital Flow Reversals (Sudden Stops)  

Eduardo A. Cavallo

Sudden stops in capital flows are a form of financial whiplash that creates instability and crises in the affected economies. Sudden stops in net capital flows trigger current account reversals as countries that were borrowing on net from the rest of the world before the stop can no longer finance current account deficits. Sudden stops in gross capital flows are associated with financial instability, especially when the gross flows are dominated by volatile cross-border banking flows. Sudden stops in gross and net capital flows are episodes with an external trigger. This implies that the spark that ignites sudden stops originates outside the affected country: more specifically, in the supply of foreign financing that can halt for reasons that may be unrelated to the affected country’s domestic conditions. Yet a spark cannot generate a fire unless combustible materials are around. The literature has established that a set of domestic macroeconomic fundamentals are the combustible materials that make some countries more vulnerable than others. Higher fiscal deficits, larger current account deficits, and higher levels of foreign currency debts in the domestic financial system are manifestations of weak fundamentals that increase vulnerability. Those same factors increase the costs in terms of output losses when the crisis materializes. On the flip side, international reserves provide buffers that can help countries offset the risks. Holding foreign currency reserves hedges the fiscal position of the government providing it with more resources to respond to the crisis. While it may be impossible for countries to completely insulate themselves from the volatility of capital inflows, the choice of antidotes to prevent that volatility from forcing potentially costly external adjustments is in their own hands. The global financial architecture can be improved to support those efforts if countries could agree on and fund a more powerful international lender of last resort that resembles, at the global scale, the role of the Federal Reserve Bank in promoting financial stability in the United States.


Capital Controls: A Survey of the New Literature  

Alessandro Rebucci and Chang Ma

This paper reviews selected post–Global Financial Crisis theoretical and empirical contributions on capital controls and identifies three theoretical motives for the use of capital controls: pecuniary externalities in models of financial crises, aggregate demand externalities in New Keynesian models of the business cycle, and terms of trade manipulation in open-economy models with pricing power. Pecuniary and demand externalities offer the most compelling case for the adoption of capital controls, but macroprudential policy can also address the same distortions. So capital controls generally are not the only instrument that can do the job. If evaluated through the lenses of the new theories, the empirical evidence reviewed suggests that capital controls can have the intended effects, even though the extant literature is inconclusive as to whether the effects documented amount to a net gain or loss in welfare terms. Terms of trade manipulation also provides a clear-cut theoretical case for the use of capital controls, but this motive is less compelling because of the spillover and coordination issues inherent in the use of control on capital flows for this purpose. Perhaps not surprisingly, only a handful of countries have used capital controls in a countercyclical manner, while many adopted macroprudential policies. This suggests that capital control policy might entail additional costs other than increased financing costs, such as signaling the bad quality of future policies, leakages, and spillovers.


Foreign Exchange Intervention  

Helen Popper

The practice of central bank foreign exchange intervention for a time ran ahead of either compelling theoretical explanations of its use or persuasive empirical evidence of its effectiveness. Research accelerated when the emerging economy crises of the 1990s and the early 2000s brought fresh data in the form of urgent experimentation with foreign exchange intervention and related policies, and the financial crisis of 2008 propelled serious treatment of financial frictions into models of intervention. Current foreign exchange intervention models combine financial frictions with relevant externalities: with the aggregate demand and pecuniary externalities that inform macroeconomic models more broadly, and with the trade-related learning externalities that are particularly relevant for developing and emerging economies. These models characteristically allow for normative evaluation of the use of foreign exchange intervention, although most (but not all) do so from a single economy perspective. Empirical advances reflect the advantages of more variation in the use of foreign exchange intervention, better data, and novel econometric approaches to addressing endogeneity. Foreign exchange intervention is now widely viewed as influencing exchange rates at least to some extent, and sustained one-sided intervention; and its corresponding reserve accumulation appear to play a role in moderating exchange rate fluctuations and in reducing the likelihood of damaging consequences of financial crises. Key avenues for future research include sorting out which frictions and externalities matter most, and where foreign exchange intervention—and perhaps international cooperation—properly fits (if at all) into the blend of policies that might appropriately address the externalities.