A Framework for Macroeconomic Stability in Emerging Market Economies

In this paper, sectoral balance sheets and sectoral stock and flow consistency are embedded into a new open economy model based on the financial accelerator. The framework has nominal inertia, real rigidities and market frictions, and it is designed to evaluate exchange rate risk in the economy and across sectors. The model is perturbed by a shock to investor sentiment and a sudden stop to capital inflow. It is used to evaluate the claims that usually back the fear of floating strategy: the effect of the exchange rate on foreign debt, and the pass-through of exchange rate depreciation to inflation. We conclude that fear of floating, the policy that intends to stabilize foreign debt, is precisely the policy that leads to a higher increase in the government debt to GDP ratio. The reason is that, in order to control the exchange rate, the authorities have to increase interest rates. While a lower depreciation does contain the level of debt, it increases the cost of interest on the debt, and this increases the change in the debt to GDP ratio. The pass-through does not seem an important argument for fear of floating either. We also find that under fear of floating the transfer problem is solved by the private sector alone in the midst of a recession; and that under floating, the government balance is in surplus thereby contributing to the transfer..