Remittances, Monetary Policy, and Partial Sterilization

[Author Affiliation]Diego E Vacaflores, , , , dv13@txstate.edu[Acknowledgment]The author thanks Dennis W. Jansen for his insightful contributions and continuous guidance. I also thank the editor, Kent Kimbrough, and two anonymous referees for their valuable comments and suggestions.1. IntroductionRemittances have increased over the last several decades. International estimates of official remittance flows suggest that the total amount of worker remittances have increased to US$300 billion in 2010 (Inter-American Development Bank 2012). This increase may in part be attributed to the rapid growth of money transfer institutions, which has reduced the average transaction cost and has made them more visible. However, it may also be indicative of an actual increase in these monetary transfers due to increased migration flows, which now represent approximately 45% of net private capital flows to developing countries.The importance of remittances for remittances-receiving developing countries does not just come from their size, but mainly from its potential and actual effects on both the society and the individual. Remittances affect labor market decisions, school retention, export-sector competitiveness, and financial deepening (Funkhouser 1992; Glytsos 2002; Cox-Edwards and Ureta 2003; Amuedo-Dorantes and Pozo 2004; Chami, Fullenkamp, and Jahjah 2005; Giuliano and Ruiz-Arranz 2009). In terms of consumption, remittance flows have gone from satisfying basic needs to providing a vast array of durable goods for recipient households. They can thus potentially promote economic growth and development through higher domestic demand if motivated by altruism or through enhanced productive capacity if motivated by self-interest.Most of the literature on remittances focuses on the microeconomic implication of such flows for the sender and for the receiver of these funds. On the basis of survey data, this trend in the literature has examined the motivations to remit, such as contractual arrangements, altruism, repayment of migration costs, and so on, and the uses of these funds in the home country (e.g., for education, health care, entrepreneurial initiatives, social works, etc.). At the macro level, the literature on the impact of remittances on the recipient country is sparse but growing as researchers realize that it could have important effects on the overall economy.However, economists have overlooked the examination of the potential influence that higher levels of remittances can have on the implementation of monetary policy, and thus its understanding is still limited. Since remittances provide a secondary income to households, they would affect decisions with respect to labor supply and consumption, which can alter the effectiveness of monetary policy when this additional income is a significant portion of a household's income. Additionally, although domestic governments usually try to sterilize capital flows to sustain a given policy, the high levels of informality in some developing countries and the significant portion of remittances that continue to flow through informal channels make monetary targeting problematic. Given these potential complications, monetary policy could potentially have a differential impact depending on the remittances' share of GDP, and fluctuations in remittances can affect the amount of money in circulation and therefore economic performance. Accounting for such influences thus became imperative for stabilization policy.This study examines the potentially different impact that monetary policy can have on output depending on the relative share of remittances as a percentage of GDP and the differential effect that remittances shocks can have on the main macroeconomic aggregates when economies do not fully sterilize such inflows--channels never explored before. It builds on the theoretical model developed by Jansen, Vacaflores, and Naufal (2010), explicitly incorporating remittances in a small open economy framework, and is able to show that monetary policy has a differential effect on output depending on the relative size of these remittances. …