Comments and Discussion

Guillermo A. Calvo:

Monetary and exchange rate policy is a topic that does not seem to suffer from decreasing marginal returns. The more economists write about it, the greater the number of twists and puzzles that are revealed. The topic has gained further impetus recently due to the seemingly unending succession of crises in emerging market economies (EMs). One view is that these crises owe much of their virulence to futile attempts to peg the exchange rate. According to this view, a floating exchange rate would have allowed these economies to bend but not break. On the other hand, there is the view that EMs suffer from credit crises (for example, sudden stops of capital inflows) for which exchange rate flexibility is no cure and could worsen the disease.¹ This view focuses on factors like: (1) existence of sizable dollar debts (that is, foreign exchange denominated debts); (2) poor credibility of policy and policymakers, grounded in a long history of monetary mismanagement; and (3) dollar-priced tradable goods (exports and raw material imports). Under those circumstances, sharp changes in the exchange rate could cause serious damage to firms' balance sheets and generate further credit difficulties.

The literature available before recent crises (starting with the Mexico 1994–95 crisis) tended to ignore financial considerations. Therefore shocks to firms' balance sheets could simply not be addressed. Velasco takes into account factor (1) listed above, namely, dollar debts and, in that fashion, brings theory closer to the current policy debate. The rest of the model draws heavily from Mundell-Fleming and assumes sticky prices. In that context, a currency devaluation creates financial difficulties to firms burdened by dollar debts and that cater to the local peso market. On the other hand, if devaluation is the result of expansionary monetary policy, firms' profits might increase and at least partially offset higher debt service (in terms of pesos). The paper shows that there are a variety of circumstances in which the profit effect dominates and, therefore, expansionary monetary policy-cum-devaluation could successfully cushion the negative effects of, for instance, an export contraction.

The paper has the virtue of simplicity and relevance, a combination that only a masterful hand can achieve. But I doubt that the present version of the paper will have a major impact on the way we think about these issues. In the first place, the author admits that the model leaves aside crucial issues like credibility, and lags in the effect of monetary policy. Consider the latter. An expansionary monetary policy is likely to result in currency devaluation, first, and in output expansion, later. Thus given the sizable exchange rate overshooting experienced in EMs, the ax of bankruptcy could hit much earlier than the restorative winds of aggregate demand.

For credibility, a model should at least be able to rationalize stylized facts. A key stylized fact in this field is fear of floating—that is, the evidence that a large set of EMs appear to be reluctant to let their exchange rates fluctuate as much as in advanced economies.² The way the paper is written, however, one gets the impression that full exchange rate flexibility wins most of the time, which, by the above criterion, weakens the model's credibility. However, I believe this implication would be dead wrong. A Velasco-type model can explain fear of floating. To prove it, notice that the peso debt burden increases linearly with the exchange rate while, in any reasonable model under price stickiness, return to capital (in peso sectors) has an upward bound. Moreover, beyond a certain point, devaluation will lead to an upward revision of peso prices, which would result in higher inflation without further output expansion. Thus a Velasco-type model could explain policymakers' reluctance to implement large devaluation, while at the same tolerating and even encouraging some exchange rate flexibility.

Consequently, I do not see this paper as debunking the notion that EMs find it hard to have an independent monetary policy. What the paper actually shows is that the Argentina-Hong Kong super-fixed rates need not be the optimal solution. But, if this is...