Optimal monetary policy under sudden stops

Emerging market economies often face sudden stops in capital inflows or reduced access to the international capital market. This paper analyzes what monetary policy should accomplish in such an event. Optimal monetary policy induces higher interest rates and exchange rate depreciation. The interest rate hike discourages borrowing and consumption, mitigating the impact of the increased cost of borrowing. The exchange rate depreciation provides a boost to export revenues, reducing the need for, but not averting, a domestic recession. The paper shows that the arrival of the sudden stop further aggravates the time inconsistency problem. Optimal policy is fairly well approximated by a flexible targeting rule, which stabilizes a basket composed of domestic price inflation, exchange rate and output. We show that from a welfare perspective, the success of a fixed exchange rate regime depends on the economic environment. For the benchmark parameterization, the peg performs the worst of the simple rules considered. For alternative parameterizations that feature low nominal rigidities or high elasticity of foreign demand, the fixed exchange rate regime performs relatively better.