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Capital Flows and Financial Stability: Monetary Policy and Macroprudential Responses

Listed author(s):
  • D. Filiz Unsal

    (International Monetary Fund)

The resumption of capital flows to emerging-market economies since mid-2009 has posed two sets of interrelated challenges for policymakers: (i) to prevent capital flows from exacerbating overheating pressures and consequent inflation, and (ii) to minimize the risk that prolonged periods of easy financing conditions will undermine financial stability. While conventional monetary policy maintains its role in counteracting the former, there are doubts that it is sufficient to guard against the risks of financial instability. In this context, there have been increased calls for the development of macroprudential measures globally. Against this background, this paper analyzes the interplay between monetary and macroprudential policies in an open-economy DSGE model. The key result is that macroprudential measures can usefully complement monetary policy under a financial shock that triggers capital inflows. Even under the “optimal simple rules,” introducing macroprudential measures improves welfare. Broad macroprudential measures are shown to be more effective than those that discriminate against foreign liabilities (macroprudential capital controls). We also show that the exchange rate regime matters for the desirability of a macroprudential instrument as a separate policy tool. Nevertheless, macroprudential measures may not be as useful in helping economic stability under different shocks. Therefore, shock-specific flexibility in the implementation is desirable.

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Article provided by International Journal of Central Banking in its journal International Journal of Central Banking.

Volume (Year): 9 (2013)
Issue (Month): 1 (March)
Pages: 233-285

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Handle: RePEc:ijc:ijcjou:y:2013:q:1:a:10
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