Hot Money and Serial Financial Crises

When one region of the world economy experiences a financial crisis, the world-wide availability of investment opportunities declines. As global investors search for new destinations for their capital, other regions will experience inflows of hot money. However, large capital inflows make the recipient countries more vulnerable to future adverse shocks, creating the risk of serial financial crises. This paper develops a formal model of such flows of hot money and the vulnerability to serial financial crises. It analyzes the role for macro-prudential policies to lean against the wind of such capital flows so as to offset the externalities that occur during financial crises. Summarizing the results of our model in a simple policy rule, the paper finds that a 1 percentage point increase in a country's capital inflows/GDP ratio warrants a 0.87 percentage point increase in the optimal level of capital inflow taxation.