Discussion of«Monetary and Macroprudential Policies

to Manage Capital Flows»by Juan Pablo Medina and Jorge Roldós

Hakan KaraCentral Bank of the Republic of Turkey

2013 CENTRAL BANK MACROECONOMIC MODELING WORKSHOP “Understanding the Mechanisms and Effects of New Policy Instruments”

November 7-8, 2013 İstanbul

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Outline

1. What does the paper do? Main contributions2. Appraisal3. Can this model be used for policy advice to EMEs?4. On the choice of alternative policy frameworks5. RR as a policy tool6. Shock robustness

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Motivation, main question, and findings

Motivated by the post-Lehman behavior of EMEs (Brasil, Turkey, Colombia, Peru)

Main Question: What is the appropriate mix of monetary and macroprudential policies when changes in world interest rate is the dominating shock?

Answer: Using a macroprudential instrument (such as RR) improves welfare significantly compared to IT regime.

Each instrument (policy rate and RR) should be paired with the objective on which it has the most influence.

(Immediate thought: do we really need a 45 equation model to make these conclusions?)

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Methodology and Execution

Set up a model with financial friction and nominal rigidity • Enhanced financial accelerator, price stickiness

Simulate the model with a foreign interest rate path similar to the one observed in post-Lehman period.

Rank the welfare under various policy frameworks• Strict inflation targeting (IT) (inflation always hits the target) • Taylor rule• Strict IT with a macroprudential rule (reserve requirements)

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Main Contributions of the paper

Modeling: RR’s under financial and nominal frictions Policy: Simulating a specific type of policy problem

which is very relevant for many EMEs.• How to respond to capital flow cycles driven by extraordinary

movements in global interest rates?

Foreign Interest Rate

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Appraisal

Very relevant and timely question Sophisticated, state of the art modeling with plenty of

useful policy implications Well-executed (more intuition may be helpful)

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Easy to beat strict IT or Taylor Rule

IT or Taylor rule is not optimal (and not used in practice) Why not do your best with a single tool, i.e., use an optimal rule? Choose the parameters , , and in the reaction function

which minimizes the loss function Then assess if the following alternatives improve the welfare:

• An augmented version with a direct response to credit• Using a macroprudential instrument

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Is this an emerging economy model?

Involves financial accelerator, rather than sudden stop:Agency problem (Bernanke, Gertler and Gilchrist 1999) + fire sales (Choi and Cook 2012) Acceleration mechanism is not specific to emerging economies The paper includes an extended version with dollarization

but share of external credit is fixed, only valuation effects:

i*↓ , rer↑ , net worth↑ , less need for borrowing Credit is mostly determined by the demand side? The evidence shows that capital flows and credit cycles are

mainly driven by supply (leverage behavior) of global banks.

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Capital Flows and Accelerating Mechanism: An Alternative View

Lower Global Interest Rates

Capital Inflows

Easing colleteral constraints

Currency appreciation and improved networth

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Capital Flows and Accelerating Mechanism: An Alternative View

Lower Global Interest Rates

Capital Inflows

Easing colleteral constraints

Increased supply of external credit

Currency appreciation and improved networth

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Implications for the Welfare Function The welfare metric used in the model:

may not reflect the objective of the EME policy makers EME central banks may have an incentive to smooth credit

and exchange rate cycles directly for reasons such as: • Inefficient composition of the output• Overborrowing (due to pecuniary externalities)• Probability of a sudden stop (relevant in finite sample)

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Conclusion on Turkish Monetary Policy: How fair is it?

«In particular, while the “natural” interest rate of this economy declines with the world rate, the policy rate may indeed need to be increased to accommodate reserve requirements—in contrast to the Turkey experience.»

This conclusion reflects model specific dynamics. The results would have possibly changed if:

• the credit were driven by the leverage cycles of global banks (as evidenced by Bruno and Shin 2013)

• the objective of the policy had incorporated financial stability (reducing the probability of a sudden stop and/or BoP crisis).

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Reserve Requirements as a Macroprudential Tool

In the model RR affects credit through two channels Cost channel : Liquidity Channel:

What if the CB directly participates in the interbank market?• Would liquidity channel still work? May be to a lesser extent.

𝑅𝑡𝐼𝐵−𝑅𝑡

𝐷= 𝑓 (𝑠𝑡𝑀𝐴)❑

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Robustness: what about «pull factors»?

The paper considers a specific (foreign interest rate) shock, yet draws broader conclusions regarding the policy mix.

How would the results change if the capital flows were driven by pull factors rather than foreign interest rates? A fall in country credit risk Productivity shock

Discussion of«Monetary and Macroprudential Policies

to Manage Capital Flows»by Juan Pablo Medina and Jorge Roldós

Hakan KaraCentral Bank of the Republic of Turkey

2013 CENTRAL BANK MACROECONOMIC MODELING WORKSHOP “Understanding the Mechanisms and Effects of New Policy Instruments”

November 7-8, 2013 İstanbul

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Source: CBRT.

Capital Flows, Credit , and Exchange Rate Cycles

(HP filtered, standardized)20

04Q

220

04Q

320

04Q

420

05Q

120

05Q

220

05Q

320

05Q

420

06Q

120

06Q

220

06Q

320

06Q

420

07Q

120

07Q

220

07Q

320

07Q

420

08Q

120

08Q

220

08Q

320

08Q

420

09Q

120

09Q

220

09Q

320

09Q

420

10Q

120

10Q

220

10Q

320

10Q

420

11Q

120

11Q

220

11Q

320

11Q

420

12Q

120

12Q

220

12Q

320

12Q

420

13Q

120

13Q

2

-2

-1.5

-1

-0.5

0

0.5

1

1.5

2 Loans (t) REER (t+2)Inflows (t+2)