Impact of Global Low Interest Rates to the Capital Flows and Financial Vulnerability of Small Open Economies

In this paper, we develop a dynamic stochastic general equilibrium (DSGE) model with financial frictions, to explore how the exogenous global low-interest-rate shock affect the small open economies, and study the effects of two macroprudential policies for protecting the external sector and financial system. We find that, when there are negative world interest rate shocks to ultra-low levels, small open economies will experience capital inflow surge, amplified domestic business cycles and increased financial leverage, leading to accumulation of financial vulnerability. However, the liability-side macroprudential policy depending on foreign debt leverage is effective in smoothing the fluctuations of economic variables. The other asset-side macroprudential policy depending on bank’s total asset expansion works in a similar but less effective way. The research results support that it is reasonable for emerging economies to adopt macroprudential policies in the current low-interest-rate environment, and the liability-side macroprudential policy linking with foreign debt leverage is more effective.