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Monetary Policy in Sudden Stop-Prone Economies

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  • Louphou COULIBALY

Abstract

In a model featuring sudden stops and pecuniary externalities, I show that the ability to use capital controls has radical implications for the conduct of monetary policy. Absent capital controls, following an inflation targeting regime is nearly optimal. However, if the central bank lacks commitment, it will follow a monetary policy that is excessively procyclical and not desirable from an ex ante welfare prospective: it increases overall indebtedness as well as the frequency of financial crisis and reduces social welfare relative to an inflation targeting regime. Access to capital controls can correct this monetary policy bias. With capital controls, relative to an inflation targeting regime, the time-consistent regime reduces both the frequency and magnitude of crises, and increases social welfare. This paper rationalizes the procyclicality of the monetary policy observed in many emerging market economies.

Suggested Citation

  • Louphou COULIBALY, 2018. "Monetary Policy in Sudden Stop-Prone Economies," Cahiers de recherche 06-2018, Centre interuniversitaire de recherche en économie quantitative, CIREQ.
  • Handle: RePEc:mtl:montec:06-2018
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    Cited by:

    1. Alessandro Rebucci & Chang Ma, 2019. "Capital Controls: A Survey of the New Literature," NBER Working Papers 26558, National Bureau of Economic Research, Inc.
    2. Javier Bianchi & Guido Lorenzoni, 2021. "The Prudential Use of Capital Controls and Foreign Currency Reserves," NBER Working Papers 29476, National Bureau of Economic Research, Inc.
    3. Javier Bianchi & Louphou Coulibaly, 2021. "Liquidity Traps, Prudential Policies, and International Spillovers," Working Papers 780, Federal Reserve Bank of Minneapolis.
    4. Javier Bianchi & Enrique Mendoza, 2020. "A Fisherian Approach to Financial Crises: Lessons from the Sudden Stops Literature," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 37, pages 254-283, August.
    5. Julien Bengui & Javier Bianchi, 2018. "Macroprudential Policy with Leakages," NBER Working Papers 25048, National Bureau of Economic Research, Inc.
    6. Bengui, Julien & Bianchi, Javier, 2022. "Macroprudential policy with leakages," Journal of International Economics, Elsevier, vol. 139(C).
    7. Hidehiko Matsumoto, 2021. "Monetary and Macroprudential Policies under Dollar-Denominated Foreign Debt," IMES Discussion Paper Series 21-E-04, Institute for Monetary and Economic Studies, Bank of Japan.
    8. Ogrokhina, Olena & Rodriguez, Cesar M., 2019. "The effect of inflation targeting and financial openness on currency composition of sovereign international debt," Journal of International Money and Finance, Elsevier, vol. 97(C), pages 1-18.

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    More about this item

    Keywords

    financial crises; monetary policy; capital controls; time consistency; aggregate demand externality; pecuniary externality;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F38 - International Economics - - International Finance - - - International Financial Policy: Financial Transactions Tax; Capital Controls
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • G01 - Financial Economics - - General - - - Financial Crises

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