Template-Type: ReDIF-Paper 1.0
Author-Name: Paolo Cavallino
Author-X-Name-First: Paolo
Author-X-Name-Last: Cavallino
Author-Name: Boris Hofmann
Author-X-Name-First: Boris
Author-X-Name-Last: Hofmann
Title: Capital flows and monetary policy trade-offs in emerging market economies
Abstract: We lay out a small open economy model incorporating key features of EME economic and financial structure: high exchange rate pass-through to import prices, low pass-through to export prices and shallow domestic financial markets giving rise to occasionally binding leverage constraints. As a consequence of the latter, a sudden stop with large capital outflows can give rise to a financial crisis. In the sudden stop, the central bank faces an intratemporal trade-off as output declines while inflation rises. In normal times, there is an intertemporal trade-off as the risk of a future sudden stop forces the central bank to factor financial stability considerations into its policy conduct. The optimal monetary policy leans against capital flows and domestic leverage. Macroprudential, capital flow management and central bank balance sheet policies can help to mitigate both intra- and intertemporal trade-offs. Fiscal policy also plays a key role. A higher level of public debt and a weaker fiscal policy imply greater leverage and hence greater tail risk for the economy.
Length: 50 pages
Creation-Date: 2022-07
File-URL: https://www.bis.org/publ/work1032.pdf
File-Format: Application/pdf
File-Function: Full PDF document
File-URL: https://www.bis.org/publ/work1032.htm
File-Format: text/html
Number: 1032
Keywords: capital flows, monetary policy trade-offs, emerging market economies
Classification-JEL: E5, F3, F4
Handle: RePEc:bis:biswps:1032