Posted by: Dirk | May 28, 2013

Carry trade and emerging market crises in the IS/MY model

sitges04I have been developing my own model (or better: sketch, framework?) recently, showing how the liquidity trap can be incorporated into it. I have drawn the connection between monetary aggregate and interest rate the traditional way. A lower interest rate should increase the willingness to lend and thus increase the monetary aggregate. However, there are situations where this kind of relationship might not work anymore.

Think of (nominal) interest rates from the perspective of an international investor. The higher the interest rate the more attractive a currency. Since interest rates are low in Japan, Germany, France, the UK, Canada, the US and elsewhere there is a search for yield. Higher interest rates in this environment might attract foreign capital which – depending on the reaction of the central bank – might lead to more liquidity and then more credit in the economy. Thus, a higher interest rate increases the monetary aggregate, a lower interest decreases it. This is a very special situation, but the carry trade is real. Many emerging economies are doing just fine and do not want net capital inflows to expand demand further since inflation is already a little elevated. Brazil, for instance, introduced taxes on some capital inflows to stop it. More liquidity but an appreciated currency was not what policy makers liked to see.

In the graph above you see this special case in the south-west corner. There is a liquidity trap at very low interest rates, but now the monetary aggregate is much lower than in the normal case. This kind of model might be appropriate for financial crises in emerging markets where the interest rate is used to defend the exchange rate until the flood is stemmed or the central bank runs out of reserves. In case of “original sin” when part of the liabilities of domestic institutions are financed by US dollars the availability of liquid US dollar for purposes of debt repayment is a major issue.

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