Integrated Monetary and Financial Policies for Small Open Economies

Integrated Monetary and Financial Policies for Small Open Economies
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Volume/Issue: Volume 2023 Issue 161
Publication date: August 2023
ISBN: 9798400250361
$20.00
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Topics covered in this book

This title contains information about the following subjects. Click on a subject if you would like to see other titles with the same subjects.

Economics- Macroeconomics , Economics / General , integrated policy framework , monetary policy , capital controls , foreign exchange intervention , macroprudential policies

Summary

We develop a tractable small-open-economy framework to characterize the constrained efficient use of the policy rate, foreign exchange (FX) intervention, capital controls, and domestic macroprudential measures. The model features dominant currency pricing, shallow FX markets, and occasionally-binding external and domestic borrowing constraints. We characterize the conditions for the “traditional prescription”—relying on the policy rate and exchange rate flexibility—to be sufficient, even if externalities persist. The conditions are satisfied for world interest rate shocks if FX markets are deep. By contrast, we show that to manage non-fundamental inflow surges and taper tantrums related to local currency debt, capital inflow taxes and FX intervention should be used instead of the policy rate and exchange rate flexibility. In the realistic case where countries face both shallow FX markets and external borrowing constraints, we establish that some kinds of FX mismatch regulations may reduce the external debt limit friction but worsen FX market depth. Finally, we show that capital controls and domestic macroprudential measures cease to be perfect substitutes if there is a risk that the domestic borrowing constraint binds as a result of the transmission of the global financial cycle.