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Capital Flows and Financial Stability: Monetary Policy and Macroprudential Responses

  • 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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  1. Ignazio Angeloni, 2009. "A Tale of Two Policies: Prudential Regulation and Monetary Policy with Fragile Banks," Working Papers 345, Bruegel.
  2. Tommaso Monacelli & Ester Faia, 2005. "Optimal Interest Rate Rules, Asset Prices and Credit Frictions," Computing in Economics and Finance 2005 452, Society for Computational Economics.
  3. Javier Bianchi, 2010. "Overborrowing and Systemic Externalities in the Business Cycle," 2010 Meeting Papers 96, Society for Economic Dynamics.
  4. Bianca De Paoli, 2004. "Monetary policy and welfare in a small open economy," LSE Research Online Documents on Economics 19950, London School of Economics and Political Science, LSE Library.
  5. Ignazio Angeloni, 2010. "Monetary Policy and Risk Taking," Working Papers 380, Bruegel.
  6. Emmanuel Farhi & Ivan Werning, 2012. "Dealing with the Trilemma: Optimal Capital Controls with Fixed Exchange Rates," NBER Working Papers 18199, National Bureau of Economic Research, Inc.
  7. Jeanne, O. & Korinek, A., 2010. "Managing Credit Booms and Busts : A Pigouvian Taxation Approach," Discussion Paper 2010-108S, Tilburg University, Center for Economic Research.
  8. Stephanie Schmitt-Grohe & Martin Uribe, 2012. "Prudential Policy for Peggers," NBER Working Papers 18031, National Bureau of Economic Research, Inc.
  9. repec:imf:imfwpa:09/252 is not listed on IDEAS
  10. Gulcin Ozkan & Filiz Unsal, . "External finance, sudden stops and financial crisis: what is different this time?," Discussion Papers 09/22, Department of Economics, University of York.
  11. Borgy, V. & Clerc, L. & Renne, J-P., 2009. "Asset-price boom-bust cycles and credit: what is the scope of macro-prudential regulation?," Working papers 263, Banque de France.
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