Central bank balance sheets under foreign exchange accumulation: insights from endogenous money theory and monetary policy implementation

Bouguelli R.

Gerioni E.M., Rolim L.N., Omizzolo J.A., Schiozer N.A.

Abstract During the 2000s, Brazil accumulated a substantial amount of foreign reserves through foreign exchange market interventions undertaken by its Central Bank. Mainstream economics considers such interventions a restriction to monetary policy autonomy. This article analyses the relationship between monetary policy autonomy and exchange rate regimes theoretically and empirically for the Brazilian economy. We argue that the compensation principle, as a direct derivation of the endogenous money approach, is an alternative to both the trilemma and dilemma views in the mainstream perspective. Then, we provide empirical evidence in favour of the compensation principle in the Brazilian economy by verifying the exogeneity of the interest rate and estimating a vector error-correction model (VECM) that indicates that the foreign reserves do not have a long-term effect on the monetary base, while they present a significant and large effect on the repos account. In line with the compensation view, we conclude that in the 2000s, Brazil had more monetary policy autonomy than conventional approaches would have suggested.

Åberg P., Corsi M., Grossmann-Wirth V., Hudepohl T., Mudde Y., Rosolin T., Schobert F.

Lavoie M.

Li H., Xu Y., Zhuang Y.

Mundell's trilemma theory says that capital flow, exchange rate stability, and monetary policy autonomy cannot be achieved simultaneously. Using monthly data from the People's Bank of China from 1999 to 2019, we find that the trilemma theory is not nearly as tight in China's practice as in theory, and the central bank can internally offset the effect of exchange rate volatility by ways other than the monetary base (such as central bank securities). Our results also indicate that, before 2012, monetary policy autonomy in China was weak due to the problem of ‘funds outstanding for foreign exchange’. With the reform of the Renminbi (RMB) exchange rate system in 2005, the effectiveness of central bank securities in compensating for the flow of foreign exchange reserves has gradually been strengthened in China.

Grossmann-Wirth V.

AbstractWhile it is too early to draw any firm conclusions regarding the optimal design of long-term monetary policy operational frameworks, the decision taken by the US Fed in January 2019 to cont...

Lavoie M.

This chapter focuses on the various monetary themes that have been emphasized by post-Keynesian economists and that turned out to have been validated by the events that occurred during and after the subprime financial crisis. These include interest rate targeting by the central bank, interest rate spreads, endogenous money, the reversed causality between reserves and money, the defensive role of central banks, the links between the central bank and the government, banks as very special financial institutions, the different role of the shadow banking system, and whether there are limits to the amounts of credit that banks can create. The chapter analyzes unconventional monetary policies, including quantitative easing (QE), QE for the people and 100% reserves. It also discusses the consequences, for the theory of endogenous central bank money, of the adoption of a system where the target interest rate is the interest rate on reserves.

Wang Y., Willett T.D., Li X.

Lavoie M., Fiebiger B.

Angrick S.

This paper examines the monetary policy constraints facing economies on a fixed peg or managed float regime, contrasting the Mundell-Fleming Trilemma view against the Compensation view commonly found at central banks. While the former holds that foreign exchange inflows and outflows affect the domestic money base and constrain monetary policy under non-floating regimes unless capital controls are adopted, the latter purports that endogenous sterilisation of foreign exchange flows invalidates this trade-off. The predictions of both theories are empirically evaluated for five East Asian economies using central bank balance sheets, vector error correction models and impulse response functions. The findings indicate that the dynamics for the economies studied correspond more closely to the Compensation view than the Trilemma view, suggesting that it is a sustained loss of foreign exchange reserves, not the adoption of a non-floating exchange rate regime, that imposes a relevant constraint on autonomy.

Cavoli T.

This paper derives a time-varying sterilization coefficient to examine those factors that determine the extent to which central banks might engage in monetary sterilization. There appear to be good reasons to do so: Sterilization neutralizes the monetary impact of reserve accumulation, which is an endogenous consequence of sustained capital inflows under some degree of management of exchange rates. A pooled sample of Asian economies incorporating Indonesia, Korea, Malaysia, the Philippines, Singapore and Thailand, for 1994–2012 is employed. We find that this method does help to directly uncover the determinants of sterilization, and while capital inflows do not appear to influence the sterilization directly, there is substantial evidence to suggest it does so indirectly—particularly through domestic interest rates.

Yang S.

Lavoie M.

Fullwiler S.T.

Lavoie M., Wang P.

This paper extends the theory of demand-led money supply endogeneity to the case of an open economy with a fixed exchange rate. This theory is contrasted to the standard Mundell-Fleming view. In the compensation approach advocated here, central banks are able to set interest rates, even in a fixed exchange rate regime, either because there are automatic market mechanisms that will induce the private sector to act in such a way that changes in foreign reserves will be compensated by opposite changes in central bank claims over the domestic economy, or because the central bank will engage in endogenous sterilization operations in its efforts to enforce its benchmark interest rate. Analyzing the balance sheet of the Chinese central bank, we find that the large rise in foreign reserves on the asset side is compensated by large positive changes in items of the liability side, mainly bonds issued by the central bank. Foreign reserves are not cointegrated with the monetary base, meaning that there is no long-run...