Optimal monetary policies in emerging markets

This dissertation addresses two types of policy reactions that were observed during the last turbulent years in emerging markets. It provides some evidence and presents two models to rationalize the behavior of the monetary authorities regarding the way they allow the nominal exchange rate to float and regarding the management of aggregate liquidity around a crisis time. The models share the features of the standard general equilibrium small open economy model, where agents are blessed with perfect foresight.; Chapter 1, “Optimal fear of floating: The role of currency mismatches and fiscal constraints”, provides an explanation to the fact that the relative volatility of the nominal exchange rate with respect to international reserves is lower in emerging than in developed economies. It relies on two empirical regularities about emerging markets: they face fiscal restrictions during turbulent times and they have a mismatch in the currency denomination of their assets and liabilities. These two features make both interventions and depreciations costly; as a result, policymakers have to choose the optimal policy mix, in order to minimize costs. The results suggest that the amount of intervention will depend on the degree of currency mismatch between assets and liabilities, the elasticity of money demand, and the relative size of the financial system. It would be expected that countries with a high degree of currency mismatch and big financial sectors would intervene heavily in foreign exchange markets, as long as the money demand is not too sensitive to the nominal interest rate. These results are roughly consistent with the empirical evidence presented in the chapter.; Chapter 2, “The optimal behavior of reserve requirements during a bank run”, is concerned about the fact that in most crises there is a reversal in the capital flows that makes fresh funds scarce. Under some circumstances, policymakers buffer the impact of that reversal through changes in the reserve requirements. To understand this behavior, the chapter obtains the optimal policy rule for reserve requirements in an environment with costly banking, an externality in the financial sector, and where capital mobility is not perfect. The results suggest that the path of reserve requirements would depend on the type of shock that the economy receives and the effect that this shock produces on the interest rate. It is shown that when there is a shock to the interest rate, the size of the risk premium will affect the response of the economy. In particular, the magnitude of a bank run will be directly related to the size of the risk premium. It is also shown that the dynamic adjustment will be slightly different for permanent and temporary shocks, and it will also depend on the access to foreign funds that the economy has. In general, these paths are consistent with the evidence for Argentina, which is analyzed in detail in the chapter.