Financial and price stability in emerging markets: the role of the interest rate

BIS Working Papers  |  No 717  | 
04 May 2018



Should central banks in emerging markets take systemic risk into account when making monetary policy decisions? We study the issue by allowing for financial risk in the standard open economy model used by policymakers around the world.


The Great Financial Crisis of 2007-09 has highlighted the need for policymakers to address financial risk concerns. Some commentators suggest that central banks should take account of financial risk in setting the policy rate. In particular, they propose "leaning against the wind", by which central banks should raise interest rates when financial imbalances accumulate. However, research on "leaning against the wind" has concentrated on the experience of advanced economies. Little is known about the advisability of such policies in emerging markets, where capital flows are important contributors to financial imbalances.


We study the issue in the open economy framework used by central banks around the world and calibrate it for Mexico. We find that, in emerging markets, "leaning against the wind" considerations for conducting monetary policy are weakened. In fact, higher interest rates attract additional capital flows, which in turn fuel domestic credit growth and the accumulation of financial imbalances.



The Global Financial Crisis opened a heated debate on whether inflation target regimes must be relaxed and allow for monetary policy to address financial stability concerns. Nonetheless, this debate has focused on the ability of the interest rate to "lean against the wind" and, more generally, on the accumulation of systemic risk arising from the macro-financial challenges faced by advanced economies. This paper extends the debate to emerging markets by developing micro-foundations that allow extending a simplified version of the New-Keynesian credit augmented model of Curdia and Woodford (2016) to a small-open economy scenario, and by subsequently using the same empirical strategy as Ajello et al. (2015) to calibrate the model for Mexico. The results suggest that openness in the capital account, and in particular a strong dependence of domestic financial conditions on capital flows, diminishes the effectiveness of monetary policy to lean against the wind. Indeed, in the open-economy with endogenous financial crises, the optimal policy rate is even below the level that would prevail in the absence of endogenous financial crisis and systemic risk.

JEL classification: E52, F32

Keywords: leaning against the wind, global financial cycle, monetary policy, financial stability