Abstract
Theory predicts that the optimal foreign exchange rate policy of a central bank, in the presence of perfect capital mobility, and a persistent expansionary fiscal policy, is to fix this rate. Since these fundamentals apply to Lebanon, the Lebanese central bank has judiciously followed the policy of pegging the foreign exchange rate since the end of 1998. However, the actual policy led to a frantic quest for foreign exchange more than the level required or optimal. The behavioral model estimated in this paper worked endogenously from 1994 to 1998, and was actively operated upon afterwards. The model, based on financial engineering concepts, relates the change in the foreign exchange reserves of the central bank to the change in foreign exchange reserves of the banking system, and to the change in the foreign public debt. This model assumes that the central bank swaps government debt, denominated in Lebanese pounds, for a debt in foreign currency, thereby increasing its reserves, and improving the balance of payments. Moreover, the model is based upon the notion that the central bank is able to persuade banks to sell their excess foreign funds abroad for floating notes issued by the central bank, thereby increasing its reserves and improving the balance of payments. Although the central bank has announced publicly that it carried out the financial engineering embodied in the behavioral model discretely, and at specific periods, the paper finds that the same policy was continuously and incessantly undertaken and implemented, but at smaller scales. The crucial evidence comes about from the empirical finding that the change in the net foreign reserves of banks is positively, proportionately and significantly related to the central bank change in foreign exchange reserves. Moreover, part of the increase in foreign debt is funneled to a positive, and significant, relation with the change in foreign reserves of the central bank.
Highlights
One of the tenets of international finance is the “impossible trinity”
Adding the possibility of an asymmetric, non-linear, relation, the econometric model is as follows: BDL = β1 + β2DUMMY ∗ BANKS + β3 (1− DUMMY ) ∗ BANKS + β4∆ ( DEBT ) + β5 AR (1) + ε. In this equation BDL is the change is the foreign exchange reserves of the central bank (Banque du Liban), BANKS is the change in foreign exchange reserves of the Lebanese banking system, ∆ ( DEBT ) is the change in the public debt in foreign currency of the Lebanese government, and DUMMY is an indicator variable that takes the value 1 if BANKS is negative, and zero otherwise
The central bank has judiciously followed a policy of pegging the foreign exchange rate
Summary
Domestic monetary policy cannot be independent in the presence of perfect capital mobility and fixed exchange rates, whereas fiscal policy is very effective and powerful in the same situation. This follows from the open economy IS/LM framework, as formulated by Mundell and Fleming, and which is still a paradigm in the international economics literature. An expansionary monetary policy will lead, at least in the short run, to a rise in aggregate output, coupled with a fall in the domestic interest rate. Foreign exchange reserves of the central bank will automatically be depleted, leading to a decrease in the monetary base, which results in a lower money supply. The ultimate contraction in the money supply totally reverses the initial expansionary policy, revealing policy incapacity
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