Monetary Policy, Inflation Targeting, the Current Account, and Economic Growth
A reflection on the relationships among the exchange rate, interest rates, foreign saving, investment, and macroeconomic vulnerability.
1. Monetary and Exchange-Rate Policy
Monetary policy consists of a set of actions carried out by the monetary authority with the aim of maintaining low and stable inflation.
The monetary-policy framework adopted by each country depends on the characteristics and circumstances of its economy. The chosen framework must take into account its interaction with other economic variables, including major economy-wide prices such as the interest rate and the exchange rate, as well as economic growth, the utilization of productive resources, the state of public finances, and other relevant variables.
Exchange-rate policy forms part of monetary policy and comprises the actions undertaken by a central bank to ensure that the behavior of the nominal exchange rate remains consistent with prevailing conditions in the foreign-exchange market and with the evolution of the variables determining this macroeconomic price over the long run.
In particular, an inflation-targeting regime in an economy open to international capital flows requires the monetary authority to shift its principal focus away from the exchange rate and toward the variables that affect the general price level.
The exchange rate nevertheless remains a highly important variable, especially in an economy characterized by substantial commercial and financial openness. For this reason, many countries adopt managed-floating exchange-rate regimes, preserving the central bank’s ability to intervene when exchange-rate variability threatens stability or even the inflation objective itself.
2. The Current Account, Foreign Saving, and Inflation
A current-account imbalance may be the expression of a greater need for foreign saving. When skilled labor is underemployed and an economy seeks to use that productive capacity to achieve higher economic growth, greater investment is required. That investment, in turn, must be financed through either domestic or foreign saving.
In a middle-income society, increasing domestic saving can be difficult, so the economy may instead complement it with foreign saving. The expression of this need for external saving is a deficit in the real side of the balance of payments. From this perspective, such deficits are not necessarily a problem in themselves; they may arise from the financing needs of a developing economy.
Under these circumstances, persistent dissaving may be reflected, for example, in a depreciation of the nominal exchange rate. Through imported goods, services, and raw materials, such a movement may be transmitted to the general price level.
If imports exceed exports, additional foreign currency is required, raising net demand for dollars in the domestic market. This may increase the nominal price of the dollar relative to the domestic currency and generate inflationary pressure. Under an inflation-targeting regime, the monetary authority will attempt to contain that pressure through contractionary monetary policy.
The interest rate is the principal monetary-policy instrument under an inflation-targeting framework because of its influence on agents’ intertemporal consumption and saving decisions and therefore on aggregate demand.
In the argument developed here, monetary tightening operates through an increase in the interest rates relevant to the monetary-transmission mechanism1. Higher financing costs discourage the borrowing of money-capital for investment, thereby slowing economic activity in subsequent periods.
External deficit → greater net demand for foreign currency → nominal depreciation → pressure on domestic prices → contractionary monetary response → higher interest rates → weaker subsequent investment and aggregate demand.
3. Interest Rates, Capital Flows, and Appreciation
Contractionary monetary policy has another effect, however. An interest-rate differential favorable to the domestic economy may attract lenders of money-capital and encourage capital inflows from abroad.
This differential can generate a greater supply of dollars as foreign lenders exchange their foreign currency for domestic currency. The relative demand for the domestic currency therefore increases, potentially leading to an appreciation of the nominal exchange rate. That nominal appreciation may, in turn, be reflected in an appreciation of the real exchange rate.
Real appreciation may increase the vulnerability of the national economy through a relative contraction of exports vis-à-vis imports. A real appreciation reduces price competitiveness2: imports become relatively cheaper, while domestic production becomes more expensive relative to foreign counterparts and may therefore lose demand in international markets.
Under such circumstances, the current-account deficit may increase not because of an original need for foreign saving, but because relative prices in the domestic economy have changed with respect to the rest of the world.
4. Debt, Investment, and Macroeconomic Vulnerability
The subsequent appreciation may weaken the external sector while simultaneously interacting with the fiscal position. Contractionary monetary policy implies higher interest rates, meaning that government debt issuance and access to domestic financing occur at a higher cost.
The composition of creditors also matters. When a larger proportion of public indebtedness is held by residents, the structure of risk differs from that prevailing when debt is primarily held by non-residents, since the consequences of financial deterioration fall directly upon agents within the domestic economy.
Inflation → monetary policy → interest rates → cost and dynamics of external debt.
Inflation → exchange rate → relative prices → external sector → external deficit.
The result may be a public sector facing a larger imbalance and an external sector providing less financing for investment needs, particularly when a growing share of available financing is redirected toward the government.
Resources may consequently become insufficient to finance the investment required for economic growth. The point is not simply that “saving is invested,” but rather that achieving a given rate of economic expansion requires minimum levels of investment. If those investment requirements are not met, the desired growth cannot be generated, especially when the objective is to achieve growth rates exceeding population growth.
GDP cannot grow in subsequent periods unless the necessary investment takes place. In its most basic sense, investment consists of producing goods and services that are not directly consumed but are instead employed in the production of additional goods and services, thereby creating the capacity for future production to exceed present production. In other words, the objective is to secure capital accumulation.
The risk of an unsustainable debt dynamic
Over the long run, the persistence and expansion of the deficit could generate a situation in which the national economy becomes insolvent because of the accumulated level of debt. This may result in the closure of credit and other financing channels, including sovereign bond issuance, refinancing arrangements, and interbank financing.
Banks holding a significant share of the securities issued by a government that becomes unable to meet its obligations may see those assets become uncollectible or lose value following a deterioration in the sovereign credit rating. The deterioration of bank assets can, in turn, reduce the willingness of other financial institutions to lend to those banks, amplifying financial fragility.
A balance-of-payments crisis could also lead to a sharp devaluation. When a central bank uses international reserves to defend a particular exchange-rate level, its ability to intervene diminishes as those reserves are depleted. A very large increase in the exchange rate may intensify the pass-through to domestic prices, making it progressively more difficult to sustain the nominal value of the currency through intervention.
An increase in the risk premium requires greater compensation through interest rates, while higher exchange-rate risk may also induce foreign investors to demand additional compensation in terms of expected foreign-currency returns.
Depreciation or expectations of devaluation also increase the risk faced by borrowers whose liabilities are denominated in foreign currency while their incomes are received in domestic currency. A deterioration in their solvency may be transmitted to the banks that extended credit to them, reinforcing the fragility of the financial system.
A characteristic of a debtor country is its need for a continuous flow of credit to honor its obligations. If payments cease, sources of credit may close. Under such circumstances, central banks may use their reserves to defend the prevailing exchange rate and provide the foreign currency required for the functioning of the economy, progressively depleting those reserves.
This dynamic becomes particularly delicate when exchange-rate defense takes place alongside a progressive contraction in sources of financing. Foreign direct investment flows, like other sources of capital, are sensitive to conditions that raise uncertainty or threaten the free movement of capital.
5. Saving, Investment, and External Financing
In the Keynesian saving-investment identity, total saving comprises both domestic and foreign saving. Domestic saving, in turn, consists of public saving and private saving, while foreign saving is associated with the current-account balance.
It is therefore useful to ask how much saving can be generated by an economy with a low level of income. In the argument developed here, its capacity for domestic saving is limited. It consequently depends on foreign saving to finance the investment required to sustain future growth, with the expectation that higher income levels will eventually make it possible to finance an increasing share of investment through domestic saving.
A government running a deficit is a government that is dissaving.
It is positive but limited because the economy has a low level of income. The marginal propensity to save is not constant with respect to income and varies as income changes. Moreover, domestic saving is not only scarce: a substantial part of it may be absorbed by the government because of its financing requirements. Under these conditions, the rest of the world plays a central role in financing investment.
It is fed by the saving of economic agents that generate small surpluses. Neither the financial system nor the non-financial private sector can necessarily offset government dissaving and independently generate enough domestic saving to finance required investment. This is why foreign saving becomes particularly important for a small economy.
When is a current-account deficit healthy?
A current-account deficit is more sustainable when the financial flows used to finance it consist of long-term capital, especially foreign direct investment.
Direct investment is long term and can generate the resources required for its own repayment through its contribution to production, employment, and, in many cases, exports, thereby producing additional foreign-exchange earnings.
Under these circumstances, export revenues help finance the profits remitted by foreign firms operating in the country, while part of the domestic expenditure undertaken by those firms —including intermediate consumption and compensation of labor— remains within the domestic economy. An additional benefit may arise through spill-over effects when technological transfer occurs.
From this perspective, a current-account deficit is better financed when it is sustained through direct investment; it is more problematic when financed through borrowing and particularly vulnerable when it depends on short-term capital, whose high mobility allows funds to leave the economy rapidly.
6. Inflation Targeting and Economic Growth
Inflation targeting tends to allow the exchange rate to operate as a major adjustment price. A nominal depreciation, insofar as it affects the real exchange rate, may stimulate exports and discourage imports.
When a country requires external financing, however, depreciation reduces the foreign-currency value of income earned in domestic currency by an investor who subsequently converts those earnings back into foreign currency. Compensating for this effect may require higher interest rates, creating an additional tension between external adjustment and the financing of investment.
Further depreciation may reinforce the stimulus to exports and the contraction of imports, thereby helping to correct the current-account imbalance. At the same time, however, tighter financial conditions may limit the resources available for investment and therefore restrict the future expansion of productive capacity.
Complementary Notes
The expression “international value of deposits” refers here to the total amount of deposits held by non-residents in the domestic economy.
When the price of a currency is said to have moved outside established margins as a consequence of foreign-exchange market pressure against it, this may refer to massive sales of the currency, which lower its relative price and generate a nominal depreciation, placing its relative value below the established lower margin.
Conversely, massive purchases of the currency raise its relative price and generate a nominal appreciation, potentially pushing its relative value above the established upper margin.
1 Monetary policy operates through the rates relevant to the transmission mechanism, particularly the monetary policy rate. This rate subsequently affects the cost at which financial intermediaries obtain funding and, later, the lending rates at which the broader economy is financed.
2 The loss of competitiveness is not caused directly by nominal appreciation but by the real appreciation that may result from it. Real appreciation raises the relative price of domestic goods compared with their foreign counterparts and therefore alters the relative prices faced by exporters.
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