Friday, November 5, 2010

U.S. Monetary Policy and Emerging Economies' Capital Controls, or "When a Butterfly at the Fed Flaps Its Wings..."

Image source: Wikimedia Commons/Tropenmuseum
A volcano in Indonesia erupts?

Well, perhaps the Fed's decision to buy $600 billion worth of Treasury bonds and the eruption of Mount Merapi (pictured at left) were not directly linked. But as Howard Schneider reported in today's Washington Post, a lot of people in Indonesia are worried that the Fed's move could have adverse effects on Indonesia's economy. How? If the Fed's punt succeeds in pushing U.S. interest rates even lower, then investors might seek to move their money to places where they can get a better yield -- and emerging economies like Indonesia's are prominent on their radar screens. If investors seek to buy more assets in Indonesia, then they may bid up the price of those assets. Increased demand for Indonesia's currency, the rupiah, could cause it to appreciate (i.e., to become more expensive vis-a-vis other currencies). And this would make Indonesia's exports more expensive.

As Schneider reports, emerging economies' fears are causing them to consider ever more seriously the wisdom of using capital controls. Liberal economists long argued against them (while iconoclasts like Joseph Stiglitz argued in their favor) but now many economists and policymakers acknowledge that they can be useful if applied judiciously. My own, evolving, view: like many regulatory measures, they have ample potential for legitimate use and harmful abuse. It will be interesting to watch in the coming months how and to what extent countries apply them and how their economies perform. Raw material for many interesting empirical investigations (and op-eds) to come...

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