Real Exchange Rate Targeting Under Capital Controls: Can Money Provide a Nominal Anchor?

IMF Working Papers, July 1, 1991

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Real Exchange Rate Targeting Under Capital Controls: Can Money Provide a Nominal Anchor?

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Bibliographic details

• Authors: Peter J Montiel, Jonathan David Ostry
• Published: July 1, 1991
• Series: IMF Working Papers
• DOI: https://doi.org/10.5089/9781451961010.001

Overview

• This paper examines whether the money supply can serve as a nominal anchor for the domestic price level under real exchange rate targeting.
• When capital controls are perfect so that there is complete separation between official and unofficial markets for foreign exchange, the domestic inflation rate can be stabilized, but only at the expense of a widening gap between official and parallel market exchange rates.
• When cross-transactions between the two markets are permitted, the steady state of the model is identical to that of a model without capital controls and, hence, the money supply cannot serve as a nominal anchor for the price level in the long run.
• If capital controls are nevertheless maintained temporarily, and are known to be temporary, targeting the money supply fails to stabilize the rate of inflation even in the short run.

Key Findings

• Under perfect capital controls (complete separation of official and unofficial FX markets):
  • The domestic inflation rate can be stabilized.
  • Stabilization occurs at the expense of a widening gap between official and parallel market exchange rates.
• When cross-transactions between official and parallel markets are permitted:
  • The model’s steady state is identical to that without capital controls.
  • The money supply cannot serve as a nominal anchor for the price level in the long run.
• If capital controls are temporary and known to be temporary:
  • Targeting the money supply fails to stabilize the rate of inflation even in the short run.

Policy Implications

• Relying on money supply targeting as a nominal anchor is conditional on the effectiveness and permanence of capital controls.
• Perfect, permanent capital controls can allow inflation stabilization via money targeting but create distortions between official and parallel exchange rates.
• Partial, porous, or temporary capital controls undermine the viability of money supply targeting for price-level stabilization.

Model Scenarios and Outcomes

• Scenario: Perfect capital controls (complete market separation)
  • Outcome: Inflation stabilized; widening gap between official and parallel market exchange rates.
• Scenario: Cross-transactions permitted between markets
  • Outcome: Steady state matches model without capital controls; money supply cannot anchor price level long run.
• Scenario: Capital controls maintained temporarily and known to be temporary
  • Outcome: Money supply targeting fails to stabilize inflation even in the short run.