Financial and real shocks and the effectiveness of monetary and macroprudential policies in Latin American countries

BIS Working Papers No 668
October 2017

Summary

Focus

This paper assesses the impact of shocks on Latin American economies and compares the effects of policies in four commodity-exporting countries in Latin America (Chile, Colombia, Mexico and Peru). Among the questions addressed are: (1) What are the effects of real and financial shocks in these countries? (2) How far do financial shocks explain investment and output growth? (3) How effective are monetary and macroprudential policies in reacting to real and financial shocks?

Contribution

Our paper makes two contributions. First, by including two key sectors (commodity exports and a domestic financial sector), our model provides a unique framework to compare the effects of financial shocks while also capturing differences across the countries. Second, we compare the use and effectiveness of macroprudential policies in Latin America.

Findings

We find that financial shocks partly explain investment and output growth in the short run but less so in the long run. Our results also suggest that macroprudential policies are effective for restoring credit and output growth in periods of financial contraction or tighter monetary policy. They are less effective in periods of low commodity prices.

 

Abstract

This work compares the impact of monetary and macroprudential policies on financial and real sectors in four Latin American countries: Chile, Colombia, Mexico and Peru, and explores the commonalities and differences in the reaction to shocks to both the financial and real sector. In order to do that, we estimate a New Keynesian small open economy model with frictions in the domestic financial intermediation sector and a commodity sector for each country. Results suggest that financial shocks are important drivers of output and investment fluctuations in the short run for most countries, but in the long run their contribution is small. Furthermore, we evaluate the ability of macroprudential policies to limit the impact on credit growth and its effect on real variables. In a scenario of tighter financial conditions, monetary policy becomes expansionary due to both lower inflation (given the exchange rate appreciation) and weaker output growth, and macroprudential policies further contribute to restoring credit and output growth. However, in the case of a negative commodity price shock, macroprudential policies are less effective but useful as a complement for the tightening of monetary policy. Higher inflation (due to the exchange rate depreciation) and higher policy rates lead to a contraction in output growth, but macroprudential policies could alleviate this by improving credit conditions.

JEL classification: E52, F41, F47

Keywords: central banking, monetary policy, macroprudential policy, financial frictions