Abstract
This dissertation consists of three chapters studying the interactions between monetary, fiscal, and capital account (MFK) policies in small open economies (SOEs). In the first chapter, I develop a theoretical framework to understand how the price level and exchange rate are determined under different MFK regimes. I identify three policy regimes where the equilibrium is uniquely determined. Two of them generalize known monetary and fiscal dominance regimes to a SOE by adding a condition that capital account policies must be consistent with external solvency. The third regime—capital account dominance—arises when policy targets the real exchange rate by strongly reacting to capital flows. This regime is therefore closely connected to common policies of terms-of-trade and real exchange rate manipulation. I show that, under these policies, the price level is uniquely pinned down as the value that balances the country's intertemporal current account condition. Inflation under this policy regime is therefore driven by current account imbalances rather than by monetary or fiscal policies. This result establishes a direct link between real exchange rate manipulation policies and monetary independence. More broadly, I show that monetary and fiscal accommodation are central to sustain these types of exchange rate policies, thus underscoring the importance of broad policy coordination to achieve price stability in SOEs. In the second chapter, I explore the implications of MFK interactions for the effectiveness and implementability of an inflation targeting framework in a SOE. First, I show that in an incomplete markets SOE model with MFK interactions, the central bank is unable to target both inflation and the nominal exchange rate while also guaranteeing external debt stability, even if it uses capital controls. This result offers a new view of the policy trade-offs suggested by the traditional trilemma of international economics by adding an external debt sustainability dimension to it. This result implies that requiring external debt to be stable in equilibrium turns the trilemma into a dilemma between price and exchange rate stability. I reconcile my results with the policy trade-offs suggested by the original trilemma by distinguishing between short and long run trade-offs. In this `debt-based' trilemma for SOEs, both price and exchange rate stability objectives can be sustained in the short run by sacrificing debt stability, that is, through the rapid accumulation of external debt. In the long run, however, debt sustainability binds, as external must be eventually repaid, and policymaker are eventually faced with a dilemma between targeting inflation and stabilizing the exchange rate. This result formalizes a critical theoretical link between external debt dynamics and price and exchange rate stability in SOEs. I then turn to the theoretical conditions under which a monetary authority is able to target inflation in a SOE. Using a two-period model, I show that a monetary authority's ability to target inflation in a SOE is contingent upon the support of both fiscal and capital account policies. Specifically, I illustrate how a lack of capital account support leads to monetary contractions having the perverse effect of creating higher future inflation instead of lowering it. This result extends the `unpleasant monetarist arithmetic' result of Sargent and Wallace, 1981 by generalizing the idea of a necessary fiscal backing for monetary policy to a broader necessary fiscal and capital account backing in SOEs. The third, and final, chapter studies the case of Chile's disinflation in the late 1980s as an empirical application of the theory developed in this dissertation. I estimate a sign-restricted Structural Vector Autoregression using Bayesian techniques and argue that capital account interventions by the central bank of Chile during this period depreciated the real exchange rate and boosted growth, while also contributing to lowering inflation. I argue these outcomes constitute a puzzle from the standpoint of the two leading theories of inflation as either a monetary or fiscal phenomenon. I develop a New Keynesian model featuring MFK policy interactions as well frictions in international financial markets to rationalize this episode as an example capital account dominance. The key mechanism that can account for the joint behavior of inflation, output, and exchange rates is the effects of a policy-induced (through foreign exchange market interventions) depreciation of the real exchange rate that caused a reallocation of resources in the economy from the domestic to the export sector. By incentivizing external demand for domestic goods, the central bank's interventions caused domestic price pressures to subside. Ultimately, the inflationary effects of depreciating the peso through more expensive imports were dominated by the deflationary effect of slower real wage growth as the domestic sector expanded at a slower pace than the rest of the economy. I conclude by underscoring the value of this case study as a prime example of successful policy coordination in a SOE and how lessons from this experience can be applied to similar economies where policies of terms-of-trade management have been attempted.
