Capital Flows and Exchange Rates: A Quantitative Assessment of the Dilemma Hypothesis

In response to an unanticipated monetary policy tightening in the US, the demand/financial channel of the international transmission of the shock dominates over the expenditure-switching effect. For a typical small open economy with flexible exchange rates, credit spreads increase, while real GDP and exports fall despite a depreciation of the local currency. In an estimated two-country open economy model, financial and pricing frictions that assign a prominent role to the global reserve currency are key to account for the empirical evidence. Model-based counterfactual policy analysis suggests that, even in the presence of a global financial cycle, the exchange rate regime matters. The volatility of output and inflation is an increasing function of the weight associated to the stabilization of the exchange rate in the monetary policy rule. The introduction of countercyclical policy instruments that target either domestic credit or capital flows dampens economic fluctuations. In a fixed exchange rate regime, either instrument can limit the negative spillovers of foreign monetary policy shocks on real economic activity, but not on inflation.