The expansionary lower bound: contractionary monetary easing and the trilemma

BIS Working Papers  |  No 770  | 
21 February 2019



One of the laws of economics states that central banks in countries with flexible exchange rates and open capital accounts should be able to ensure macroeconomic stability regardless of external financing conditions. But central banks in emerging market economies (EMEs) hold a different view. They express strong concerns about the damaging effects of volatile capital flows. Some perceive the constraint as increasing their policy rates whenever financial market volatility or US policy rates increase.


This paper adds to the debate on whether EMEs can have both monetary independence and open capital accounts. This issue came to the fore following the large swings in capital flows experienced during the financial crisis and amid concerns about spillovers from US monetary tightening. We provide a theory that rationalises how capital flows can hinder monetary policy independence, even when exchange rates are flexible. 


We show that when external debt is large, the monetary independence of an EME central bank can be limited. When interest rate cuts reduce capital inflows - for example, because carry traders unwind their positions or owing to currency mismatches - the central bank may be constrained by an "expansionary lower bound" (ELB). Below this ELB threshold, monetary easing triggers capital outflows that tighten domestic credit and drag economic activity down. This amounts to a lower bound on EME interest rates that can materialise even for positive interest rates. Global financial conditions affect the ELB and thus the central bank's ability to support the economy. Tightening global financial conditions raise the ELB and can force monetary authorities to increase policy rates, thereby pushing their economies into recession. Our theory has profound policy implications. It suggests that policymakers should limit the build-up of debt by running the economy below potential when global financial conditions are supportive. It also backs the case for alternative policy tools that can be used to regain monetary space, especially unconventional monetary policies, capital controls and macroprudential measures.



We provide a theory of the limits to monetary policy independence in open economies arising from the interaction between capital flows and domestic collateral constraints. The key feature is the existence of an "Expansionary Lower Bound" (ELB), defined as an interest rate threshold below which monetary easing becomes contractionary. The ELB can be positive, thus binding before the ZLB. Furthermore, the ELB is affected by global monetary and financial conditions, leading to novel international spillovers and crucial departures from Mundell's trilemma. We present two models in which the ELB may arise due to either carry-trade capital flows or currency mismatches.

JEL classification: E5, F3, F42

Keywords: monetary policy, collateral constraints, currency mismatches, carry trade, spillovers