Integrated Monetary and Financial Policies for Small Open Economies

IntegratedMonetaryandFinancialPoliciesforSmallOpenEconomies SumanBasu,EmineBoz,GitaGopinath,FranciscoRoch,FilizUnsal WP/23/161 IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtoencouragedebate. TheviewsexpressedinIMFWorkingPapersarethoseoftheauthor(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. 2023 AUG ©2023InternationalMonetaryFundWP/23/161 IMFWorkingPaper ResearchDepartment IntegratedMonetaryandFinancialPoliciesforSmallOpenEconomiesPreparedbySumanBasu,EmineBoz,GitaGopinath,FranciscoRoch,FilizUnsal* AuthorizedfordistributionbyPrachiMishra August2023 IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtoencouragedebate.TheviewsexpressedinIMFWorkingPapersarethoseoftheauthor(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. ABSTRACT: Wedevelopatractablesmall-open-economyframeworktocharacterizetheconstrainedefficientuseofthepolicyrate,foreignexchange(FX)intervention,capitalcontrols,anddomesticmacroprudentialmeasures.Themodelfeaturesdominantcurrencypricing,shallowFXmarkets,andoccasionally-bindingexternalanddomesticborrowingconstraints.Wecharacterizetheconditionsforthe“traditionalprescription”—relyingonthepolicyrateandexchangerateflexibility—tobesufficient,evenifexternalitiespersist.TheconditionsaresatisfiedforworldinterestrateshocksifFXmarketsaredeep.Bycontrast,weshowthattomanagenon-fundamentalinflowsurgesandtapertantrumsrelatedtolocalcurrencydebt,capitalinflowtaxesandFXinterventionshouldbeusedinsteadofthepolicyrateandexchangerateflexibility.IntherealisticcasewherecountriesfacebothshallowFXmarketsandexternalborrowingconstraints,weestablishthatsomekindsofFXmismatchregulationsmayreducetheexternaldebtlimitfrictionbutworsenFXmarketdepth.Finally,weshowthatcapitalcontrolsanddomesticmacroprudentialmeasuresceasetobeperfectsubstitutesifthereisariskthatthedomesticborrowingconstraintbindsasaresultofthetransmissionoftheglobalfinancialcycle. JELClassificationNumbers: E58,F38,F41,G28 Keywords: integratedpolicyframework;monetarypolicy;capitalcontrols;foreignexchangeintervention;macroprudentialpolicies Author’sE-MailAddress: sbasu2@imf.org,eboz@imf.org,ggopinath@imf.org,froch@imf.org,funsal@imf.org,filiz.unsal@oecd.org *ThefirstdraftofthispaperwasinJuly2020,anditbuildson“AConceptualModelfortheIntegratedPolicyFramework(IPF),”WP/20/121.TheIMF’sIPFanditsInstitutionalView(IV)onTheLiberalizationandManagementofCapitalFlowsincorporateandreconcilefindingsfromthisconceptualmodel,otheranalyticalwork,countries’policyexperiences,andotherinputs.Forhelpfulcomments,wethankTobiasAdrian,MarkAguiar,ManuelAmador,TamBayoumi,JavierBianchi,MarcosChamon,MitaliDas,ChrisErceg,EmmanuelFarhi,OlivierJeanne,SebnemKalemli-Özcan,JesperLindé,MatteoMaggiori,EnriqueMendoza,andLudwigStraub;wealsothankseminarparticipantsatthe2020NBERSummerInstitutesessionsoftheInternationalFinanceandMacroeconomicsandtheMacroeconomicsWithinandAcrossBordersgroups,the2020NBEREmergingandFrontierMarketsConference,the2021AEAMeetings,theXXIVAnnualConferenceoftheCentralBankofChile,andattheBIS,OECD,ECB,FederalReserveBoard,andnumerousothercentralbanks.WealsothankthebroaderIPFteam,especiallyDavidLiptonforlaunchingtheIPFworkstreamandGiovanniDell'Aricciaforinsightfuldiscussions.TheviewsexpressedinthispaperarethoseoftheauthorsandshouldnotbeattributedtotheIMF,itsExecutiveBoard,oritsmanagement. IMFWORKINGPAPERSIntegratedMonetaryandFinancialPoliciesforSmallOpenEconomies WORKINGPAPERS IntegratedMonetaryandFinancialPoliciesforSmallOpenEconomies SumanBasu,EmineBoz,GitaGopinath,FranciscoRoch,FilizUnsal INTERNATIONALMONETARYFUND 1Introduction Manyemergingmarketsanddevelopingeconomies(EMDEs),andalsosomeadvancedeconomies(AEs),haveadoptedinflationtargetingframeworksinwhichtheuseofthemonetarypolicyrateandexchangerateflexibilityiscomplementedbytoolssuchassterilizedforeignexchange(FX)interven-tion,capitalcontrols,anddomesticmacroprudentialmeasures.Asfigure1shows,theuseofthesetoolsmaybemorefrequentatturningpointsintheglobalfinancialcycle.1 Ajustificationforsuchtoolsmayrestonthecombinationofthevolatileexternalfinancingshocksthatthesecountriesfaceandthemarketfrictionswhichamplifytheshocksintomacroeconomicdestabilization.Thisissueisparticularlysalientinthecurrentcontext,asseveralAEcentralbanksaretighteningmonetarypolicytobringdowninflationfromelevatedlevels.Figure2showsarangeofshocksandramificationsofvaryingseveritythatEMDEshavehadtomanageintherecentpast: U.S.monetarypolicytighteningandlooseningepisodes;the2013“tapertantrum”,inwhichtheannouncementofU.S.monetarytighteningledtoadisruptivespikeinuncoveredinterestparity(UIP)premiaonEMDEs’localcurrencydebt;theincidenceof“suddenstops”,moresevereeventswhichareassociatedwithacollapseinGDPgrowthandtypicallyprecededbyhighforeigncurrencydebtinflows;anddomesticbankingcrises. Countries’frequentuseofmultiplepolicytoolscontrastswiththelackofasystematicwelfare-optimizingframeworktounderstandthecomplexinteractionsacrossthe