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MONETARY AND EXCHANGE RATE POLICIES IN COLOMBIA (1991-2002). By: Sergio Clavijo November 2003 Board of Directors Central Bank of Colombia. “The only way [the FED and the Bank of England] affect inflation is by changing the amount of high-powered money……

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monetary and exchange rate policies in colombia 1991 2002

MONETARY AND EXCHANGE RATE POLICIES IN COLOMBIA (1991-2002)

By: Sergio Clavijo

November 2003

Board of Directors

Central Bank of Colombia

slide2
“The only way [the FED and the Bank of England] affect inflation is by changing the amount of high-powered money……

The difference between the two approaches is in the way they choose to describe their operations to the public, not in the actual operating procedures”.

Milton Friedman (2002) “Interview” Quarterly Journal of Central Banking (August).

slide3
Some History:
  • Flotation of the peso/dollar was adopted in September 1999, as a result of the Asian, Russian, and Brazilian crises.
  • Formal “inflation targeting” was announced in October 2000.
  • The stance of monetary policy is transmitted through the repo-rate, within a framework of “lombard rates”.
slide4
Consolidation of a trinity framework:
  • Flexible exchange rate;
  • Inflation targeting; and
  • Monetary policy rule (Taylor, 2001).
slide5
Preliminary Results:
  • Inflation has stabilized around 7%, completing four consecutive years of one digit inflation in Colombia.
  • Remarkable for a country with the most persistent moderate-inflation over the previous three decades, average inflation of 22%

(Dornbusch and Fischer, 1991).

  • Real exchange rate has depreciated by 15-20% during 1999-2003.
slide6
Systemic Risks?
  • Housing crises exploded in 1998.
  • “Last resort” money avoided contagion of the financial system.
  • Cost of the crises is 4-6% of GDP over the period 1998-2007.
slide7
Institutional Framework:
  • Constitutional mandate of the CB is hierarchical since 1991:
  • Pursue low and stable inflation, but
  • In line with government development plan, which targets higher growth and employment.
  • The BdR has only instrumental independence.
slide8

Institutional Arrangements

Banco de la República (Colombia) BdR

Federal Reserve Bank (USA)FED

Objectives

Hierarchical

Dual

Board Members

Seven (Including the Minister of Finance)

Twelve for the FOMC.

Seven for the “Discount Window”

Strategy

“Inflation Targeting” (Explicit)

“Inflation Targeting” (Implicit)

slide9

Institutional Arrangements

Banco de la República (Colombia) BdR

Federal Reserve Bank (USA) FED

Monetary Instruments: Central: Reference Rates Limiting Rates

Secondary: Aggregates

Support: Treasury

Exchange Rates:

Regime

Instruments

Crawling Bands / Flotation

Options: “puts” and “calls”

Flotation

Intervention thru Treasury

REPO and Reverse REPO

Lombard Rates-Discount Window

Monetary Corridors

/ Reference Lines

(un- announced)

Semi-Automatic

REPO (Fed.FundsRate) Discount Window

Banking Reserves

(un-announced)

Automatic

slide10
We will argue:
  • In favor of adopting “operational inflation ranges”.
  • In favor of foreign exchange “options” as a way to confront capital markets turbulence.
slide12
Conclusion:
  • The 1998-2002 episode of “opportunistic dis-inflation”: a

chance for reducing financial and wage indexation.

  • Orphanides and Wilcox (2002, Int. Fin.) argue that if:

Phillips Curve: Π = Πe + α y + s

Where y = Log Y - Log Y * and “s”: Observable Shock

Inherited Inflation (Intermediate Target): Π = λ Πo 0 ≤ λ < 1

Loss Function: La = ( Π – Π)2 + γ y2 + δ | y |

1. Under δ = 0 and λ = 0 (meaning Πo = 0), Conventional optimal result.

2. But under ( δ, λ ) > 0 (meaning Πo > 0),

Opportunistic strategy is optimal: Set output at potential whenever the:

A. Policy Makers care about output deviations (larger δ)

B. Smaller reward in disinflation in return for maintaining outp-gap (α )

C. Closer is inflation to intermediate gap (Πe + s – Π ≈ 0 )

slide13
The Board moved from inflation point-targets (1991-2002) to range-targets (2003-2005).
  • Compatible with inflation targeting and operational ranges (+/- 2% since 2001 within the IMF program).
  • Uncertainty increases as inflation converges to the long-term 3%; excessive disinflation (1999-2000), or excessive inflation (I-2003), should be avoided.
new monetary policy and exchange rate flotation in colombia
New Monetary Policy and Exchange Rate Flotation in Colombia

Four main changes:

a) Multi-annual Inflation Targets.

b) Macro Global Assessment.

c) Signaling via interest rates.

d) Fx-Options: “put” to increase NIR and “call” to decrease NIR

slide17

Foreign Exchange Options

I. “Put” Options to Buy NIR

Colombia

(1999-2002)

Mexico

(1995-2001)

Trigger Rule

Spot < Spot(MA20Days)

Spot < Spot(MA20Days)

Amount Offered in Auction

US$ 30 – US$ 200

US$ 250

Cumulative Amount Exerted

US$ 1,400

US$12,000

Net Internat. Reserves (NIR)

US$ 10,840

US$ 34,000

Amount Exerted / NIR

11.3 %

35 %

NIR / Amortization’s Due

1.0

1.2

slide18

Colombia

(1999-2003)

Mexico

(1995-2001)

Trigger Rule

Spot > Spot(MA20Days)

-------

Amount Offered in Auction

US$200 + 200 = 400

(or up to US$1 billion)

-------

Cumulative Amount Exerted

US$ 145 + 200 = 345

-------

Amount Exerted / NIR

3.3 %

-------

II. “Call” Options to Sell NIR

slide19

Colombia

(1999-2002)

Mexico

(1995-2001)

Trigger Rule

Spot +/- 4 % of Spot(MA20Days)

Spot > 2% of

Spot t-1

Amount Offered in Auction

US$ 180

US$ 200

Cumulative Amount Exerted

US$ 414

US$ 1,950

Exerted Options / NIR

3.8 %

5,7 %

III. Options to Control Volatility

slide20

Central Bank Reaction Functions:The Case of the FED

Interest Rate Rules

Theoretical Models

Estimations

1. Basic Taylor

Rule

i = r* - 0.5 * + 1.5  + 0.5 y

2. Generalized Taylor Rule

i = k + g  + g y y

i = 0.63 + 1.7  + 0.8 y + 

3. Optimal Taylor Rule

i = 2.21 + 2.8  + 1.6 y + 

4. Optimal Dynamic

i = (1-)(k +g  +g y y)+ i –1

i = 2.21 + 2.8  + 1.8 y + 

5. Optimal Lagged

i = k + g   + g y y-1

i = 2.21 + 2.5  + 1.6 y + 

slide21

Central Bank Reaction Functions:The Case of the BdR(Dependent Variable: Interbank Interest Rate)