Monetary Policy for Emerging Economies

Assistant Professor Louphou CoulibalyIf you’ve taken macro, you probably learned that central banks should cut interest rates during recessions: The lower interest rates spur investment, which helps the economy out of recession.

But central bankers in emerging economies – economies which aren’t quite all the way developed – rarely follow this advice. Instead, central bankers in countries like Indonesia, Peru, and Thailand regularly do the exact opposite, raising interest rates during recessions.   

Do these bankers understand less about economics than you? No. Instead, they realize that setting interest rates for an emerging economy is more complicated than the Econ 101 case.

New Assistant Professor Louphou Coulibaly studies these complications in his research, and offers solutions.    

Sudden stops, exchange rates, and monetary policy

Most emerging economies rely on foreign lenders to fuel investment. And this is where monetary policy gets tricky.

To see that, suppose you’re an Indonesian looking to borrow money to start a factory. Few Indonesians can loan you the funds, so you turn to an American bank.

The bank lends you the funds, in American dollars. They also asks for an assurance that you’ll pay back, so you put your house up as collateral. To rent the machines and hire the workers you need, you exchange the dollars the bank lent you for rupiahs – the currency of Indonesia.

All is well, until at some point, Indonesia experiences a Sudden Stop. A Sudden Stop is when an economy experiences an abrupt drop in foreign investment – a phenomenon which is common in emerging economies. What causes a Sudden Stop is usually difficult to pinpoint, but for one reason or another investor confidence in the Indonesian economy plummets and investors begin pulling their money from Indonesia.

As investors pull their money out, the exchange rate for dollars to rupiah plummets, as investors are demanding fewer rupiah and more dollars. What does the falling exchange rate mean for factory owners, like yourself?

It means that the loan you took out – which needs to be paid back in dollars – grew (in real terms); it’ll take more rupiahs than it originally did to repay the American bank. The falling exchange rate also means that the collateral you put up to secure the loan isn’t worth as much as before. You need to provide the bank additional capital to cover the difference. All of this leads to severe problems for businesses, and a recession results.

What can/does the Indonesian central bank do to ease the strain from a Sudden Stop? The exact opposite of what macro 101 says: the central bank raises interest rates. The higher interest rates increase the return to holding rupiahs, causing their demand to increase and strengthening the currency. But while the higher interest rates help the exchange rate, they also hurt the domestic economy – which could lower the exchange rate. Therefore, raising interest rates may hurt the economy, while not even ending the Sudden Stop.

There’s a better way

Coulibaly looks at whether raising interest rates is the best response to a Sudden Stop. And he finds it’s not.

One approach that would be preferable to raising interest rates is for a central bank to adopt a policy of inflation-targeting. Inflation-targeting is a policy through which a central bank publicly announces their desired level of price-inflation in the economy. The central bank then sets interest rates in order to hit the inflation target. 

The advantage inflation-targeting has over raising interest rates has to do with the bailout problem (also known as “moral hazard”). If borrowers believe that the central bank will raise rates when they’re in trouble, then borrowers will be encouraged to make excessively risky investments (“heads I win, tails you lose”). Because inflation-targeting is independent of borrowers’ distress, it prevents this sort of excessive risk-taking.   

Coulibaly uses an empirical model to show that a central bank which adopts inflation-targeting will experience harsher Sudden Stops, but that the frequency of those Sudden Stops will be fewer. On the whole, Coulibaly finds that inflation-targeting should be better than raising interest rates during a Stop.

But for an emerging economy to enact inflation-targeting isn’t easy. Whereas inflation-targeting requires a strong commitment on behalf of a central bank, emerging economies often take an ad-hoc approach to policymaking.

This leads Coulibaly to consider another alternative to raising interest rates during a Stop: capital controls. Capital controls are restrictions on how foreign investment enters and leaves a country. These can be limits on how much of investment is financed via foreign money, or special rules dictating how foreigners are able to take their money out of the country.

Coulibaly shows that carefully considered capital controls (e.g. restrictions on capital inflows, not outflows), along with increases to interest rates can lead to both fewer Stops, as well as less severe Stops.

Familiar with: macroeconomics, finance, and cold weather

Originally from the Ivory Coast, Coulibaly comes to Pittsburgh by way of Canada (so he’ll do okay with the weather here). There he studied economics at the University of Montreal, completing his PhD just last spring.

Coulibaly’s work on Sudden Stops is representative of his research interests, which concern international finance markets and how they affect the macroeconomy. He is currently teaching a graduate courses on International Macro and Monetary Economics.