Towards a Framework for Macroeconomic Analysis in an Emerging Market Economy
The series Working Papers on Economics is published by the Office for Economic Studies at the Banco de la República (Central Bank of Colombia). It contributes to the dissemination and promotion of the work by researchers from the institution. This series is indexed at Research Papers in Economics (RePEc).
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We develop a small open economy model with sectorial balance sheets that are exchange rate exposed and with sectorial stock and flow consistency. The model is perturbed by a shock to investor sentiment and a sudden stop to capital inflow. It is used to evaluate the claims that usually back the fear of floating strategy: the effect of the exchange rate on foreign debt, and the pass-through of the exchange rate to inflation. The conclusion is drawn that fear of floating, the policy that is intended to stabilize foreign debt, is precisely the policy that increases the government debt to GDP ratio. The reason is that, in order to control the exchange rate, the authorities increase interest rates. A lower depreciation does contain the level of debt; however, higher interest rates produce two effects. First, they increase the cost of interest on the debt. Second, they decrease tax revenue through recession. Both effects increase the change in the debt to GDP ratio. The pass-through does not seem to be an important argument for fear of floating either. We also find that during a sudden stop, regardless of whether the exchange rate is maintained or not, the economy as a whole runs a surplus. Under fear of floating, nonetheless, the government runs a deficit that overburdens the private sector. The policy implication is that during a sudden stop the exchange rate should be allowed to float. A case can be made for fear of floating if there are plans to reduce inflation.
La serie Borradores de Economía es una publicación de la Subgerencia de Estudios Económicos del Banco de la República. Los trabajos son de carácter provisional, las opiniones y posibles errores son responsabilidad exclusiva del autor y sus contenidos no comprometen al Banco de la República ni a su Junta Directiva.
