## 1. Monetary Policy, FXI, and the Impact of CFMs

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### Chapter scope and structure
- Analysis of interactions among monetary policy, foreign exchange intervention (FXI), and capital flow management measures (CFMs).
- Components included: main chapter pages 29–35; Box III.1; Annex I (model and parameterization).

### Empirical approach and samples
- Pooled panel structural VAR (monthly data 2000–2016) for 11 emerging markets: Brazil, Chile, India, Indonesia, Malaysia, Mexico, Peru, Poland, Thailand, Turkey, and South Africa.
  - Model variables: external financial and real factors, growth, inflation, NEER, policy rate, long-term interest rates, domestic credit.
  - External financial conditions: country-specific EMBI and CDS spreads, US term premia, VIX. External real factors: external demand, terms of trade, commodity prices.
  - Baseline Cholesky ordering: external financial conditions; external real conditions; domestic activity; CPI inflation; private credit growth; policy rate; long-run yields; NEER.
- Local projection estimates for 66 NREs (1996Q1–2015Q4) to estimate dynamic responses to global financial shocks (GFS approximated by Federal Funds Rates and the VIX).
- Panel regression (augmented Taylor rules) for 79 countries (2000–2013; 49 EMDCs included) to assess interactions between monetary policy, MPMs, CFMs, and FXI.

### NREs’ vulnerability to external spillovers (key findings)
- Real and financial external shocks are the largest individual drivers of volatility in small financially integrated non-reserve-issuing economies (NREs).
- External financial conditions contribute most to movements in domestic yields and the exchange rate, constraining monetary policy independence.
- External real factors are most important for growth and inflation.
- Exchange rate flexibility moderates external shock impacts; flexible regimes and targeted instruments help regain some monetary policy autonomy.
- In the 11-country VAR, domestic policy rates react directly to both external financial and external real factors; domestic yields and exchange rates remain highly sensitive to external financial shocks irrespective of policy rate changes.

### Transmission and effectiveness of instruments
- Interest-rate monetary policy in the 11 EMEs effectively influences output and inflation and transmits via long-term interest rates.
- FXI can mitigate appreciation and depreciation pressures mostly in the short run; effectiveness larger when reserves are adequate and macroeconomic imbalances are small.
- FXI impact is larger for countries with CFMs, as CFMs reduce offsetting private capital flows.
- Central banks de facto respond to financial and external stability considerations (exchange rate and credit channels); alternative instruments targeted at financial or external stability reduce the need for monetary policy to address those considerations.

### Interactions, trade-offs, and policy packages
- Overall impact of a policy package depends on shock nature and constraints on monetary transmission (including ELB/ZLB).
- Combined-instrument responses can be more effective than single-instrument responses in some cases; effectiveness depends on shock type:
  - External financing shocks: two-policy regime (interest rate + FXI) generally superior to pure float — lower output and inflation volatility obtainable.
  - Domestic demand shocks: FXI shortens duration of higher inflation and required policy rate hike but can prolong current account deficits and lower output; smoothing effect of FXI is smaller for domestic demand shocks than for external financing shocks.
- CFMs reduce sensitivity of capital flows to interest rate movements, enhance intervention effectiveness, and lead to smaller responses in policy rates and FXI for a given external shock.

### Empirical assessment of FX intervention (method and findings)
- Two-stage country-by-country regressions addressing endogeneity:
  - First stage: central bank FX intervention reaction function (depends on recent exchange rate moves and volatility, reserves, exchange rate misalignment).
  - Second stage: exchange rate as function of short-term interest rates, longer-term spreads, commodity prices, VIX, and predicted intervention; interaction terms for CFMs and MPMs.
- Findings:
  - Selling foreign reserves effectively absorbs depreciation pressures.
  - Buying foreign reserves significantly moderates appreciation pressures when reserves are adequate, capital flows are restricted, inflation is well anchored, the exchange rate is not overvalued, macroeconomic imbalances are limited, and financial markets are less developed.
  - FXI significantly influences the pace of exchange rate changes but no statistically significant impact on the exchange rate level was found.
  - When CFMs are in place, selling FX intervention has a larger impact on stemming depreciation pressures.
  - Non-spot FXI (limited experience) appears similarly effective in available cases and likely operates via portfolio and signaling channels.

### Credit, MPMs, and business cycle implications
- Credit growth significantly affects inflation and real economic conditions; inflation and real activity respond strongly to credit growth.
- Quantity-based tools (e.g., reserve requirements) are commonly used because of the credit channel’s importance.
- Tightening MPMs significantly lowers the reaction of policy rates to credit gaps; tightening CFMs or use of FXI reduces the monetary policy reaction to exchange rate gaps.
- Panel evidence suggests additional tools delay and dampen monetary policy responses to credit and exchange rate gaps.

### Case study: Russia (2014–2015) — policy event and market microstructure
- Two adverse shocks in 2014: drop in oil price and closure of access to international capital markets due to sanctions; large net capital outflows, currency depreciation, and inflationary pressures.
  - Currency depreciation: 95 percent over the course of the year (2014).
- On December 16, 2014 the Central Bank of Russia (CBR) raised the policy rate by 650 basis points to 17 percent; preceded by a 100 bps increase on December 11, 2014 and introduction of repo transactions.
- Complementary measures: temporary forbearance on loan classification, provisioning, and valuation accounting; expanded collateral for FX repo auctions; temporary easing of restrictions on banks’ lending and deposit interest rates; expanded FX liquidity provision.
- Policy normalization: key policy rate lowered by 200 basis points on January 31, 2015; by July 2015 the interest rate returned to the level prior to the December 16, 2014 hike.
- Liquidity and market microstructure around Dec. 16, 2014 (Table III.2 values as reported):
  - Bid-Ask Spread (bps):
    - Week before Dec. 16: 14.38
    - Dec. 16: 88.85
    - Dec. 17: 242.91
    - Week after Dec. 17: 64.44
    - Memo: Full Sample⅟: 10.03
  - Effective cost of transaction (bps):
    - Week before Dec. 16: 1.65
    - Dec. 16: 10.56
    - Dec. 17: 14.44
    - Week after Dec. 17: 14.60
    - Memo: Full Sample⅟: 1.06
  - Price Impact (bps):
    - Week before Dec. 16: 2.50
    - Dec. 16: 13.56
    - Dec. 17: 13.56
    - Week after Dec. 17: -0.42
    - Memo: Full Sample⅟: 0.80
  - (Additional reported row values): 4.29, -3.63, -21.76, -12.61, 0.42
  - Traded Volume (index):
    - Week before Dec. 16: 89.01
    - Dec. 16: 130.82
    - Dec. 17: 72.59
    - Week after Dec. 17: 36.78
    - Memo: Full Sample⅟: 101.95
- Market microstructure findings:
  - Bid-ask spreads increased by more than 617 percent relative to their average level during the week prior to the CBR’s announcement.
  - Effective cost of transactions increased by 640 percent over the same period; liquidity strains persisted for a few days before normalizing.
  - Impact of order flows on exchange rate returns increased significantly following the CBR’s interest rate hike and then normalized the week after the policy event.
  - Return reversal recovered to normal dynamics (negative coefficient in Table V.1).

### Modeling: Stylized New Keynesian small open economy (Annex I)
- Framework follows Escudé (2013); Dynare code by the author.
- Agents: households (consume domestic and imported goods; hold domestic bonds and foreign-currency bonds), firms (Calvo pricing), central bank issues currency M_t, domestic bonds B_t, and holds international reserves R_t.
- International borrowing rate: international risk-free rate i_t^* augmented by an endogenous risk premium depending on foreign debt-to-GDP; borrowing rate textual definition preserved:
  - 1 + i_t^DD = (1 + i_t^*)^{φ^*} τ_D (G_t D_t / P_t Y_t)
- Central bank flow budget constraint (textual form preserved):
  - M_t + B_t − G_t R_t = M_{t-1} + (1 + i_{t-1}) B_{t-1} − (1 + i_{t-1}^*) G_t R_{t-1}
  - Stylized sterilization constraint: M_t + B_t − G_t R_t = 0
- Taylor rule (textual form preserved):
  - 1 + i_t / 1 + i = ( (1 + i_{t-1}) / (1 + i) )^{h0} (π_t / π_T)^{h1} (Y_t / Y)^{h2} (e_t / e)^{h3}
  - Benchmark parameterization: h0=0.2; h1=1.2; h2=0.02; h3=0
- Intervention rule (operational target: rate of nominal depreciation δ_t):
  - δ_t / δ = (δ_{t-1} / δ)^{k0} (π_t / π_T)^{k1} (Y_t / Y)^{k2} (e_t / e)^{k3} (e_t r_t / Y_t)^{k4}
  - Baseline: k0=k1=k2=k3=0; k4=-0.005
- Central bank loss function (quadratic):
  - L = w_π Var_qr(π) + w_y Var_qr(y) + w_{Δi} Var(Δi) + w_{Δδ} Var_qr(Δδ)
- Policy regimes compared:
  - Pure float: central bank chooses Taylor rule parameters h0, h1, h2, h3.
  - Managed float: central bank chooses h0, h1, h2 and intervention parameter k4 (with k1=k2=k3=0).

### Monetary policy under the lower bound (ELB/ZLB) — interactions with fiscal and macroprudential policy
- When monetary policy is constrained (ELB/ZLB), activating macroprudential instruments (e.g., a variable levy on foreign borrowing) and fiscal measures can materially improve stabilization outcomes.
- Main model results:
  - Macroprudential policy is more beneficial than relying on a single instrument when addressing a global supply shock that lowers inflation.
  - With an active macroprudential instrument, inflation rises faster toward target and the policy rate need not be lowered as much.
  - Gains from macroprudential policy are significantly larger when monetary policy is constrained by the ELB: the macroprudential instrument helps raise inflation faster, allowing the policy rate to leave the lower bound earlier.
  - Fiscal policy combined with monetary policy also helps raise inflation faster; fiscal multipliers are higher at the ELB.
- Mechanism:
  - At the ELB, domestic bank credit becomes relatively more expensive than foreign credit → firms borrow more abroad → appreciation pressure from capital inflows (externality).
  - Macroprudential policy reduces this externality by making foreign credit more expensive relative to domestic funding → firms borrow less abroad → reduces appreciation pressure.

### Policy implications and suggested research directions
- NREs have broadened policy toolkits: greater exchange rate flexibility, MPMs, FXI, and CFMs (to a more limited degree).
- In response to COVID-19 shocks, EMs allowed exchange rates to play a large shock absorber role while use of CFMs has been limited so far.
- Key policy lessons:
  - External conditions materially constrain policy independence in NREs through exchange rate, credit, and interest-rate channels.
  - Alternative targeted instruments (FXI, MPMs, CFMs) can be complementary to traditional macroeconomic policy and reduce the need for monetary policy to lean against external or financial shocks.
  - Effectiveness of combinations depends on shock type, transmission strength, policy constraints (including ELB/ZLB), initial conditions, financial cycle stage, and costs/unintended consequences of tools.
- Suggested further work:
  - Explore effectiveness of alternative policies in softening monetary policy response to global financial shocks other than US monetary policy shocks.
  - Study interactions among instruments (CFMs/MPMs, FXI/MPMs, fiscal policy and unconventional tools including UMP).
  - Conduct granular country-level examinations given heterogeneity in policy transmission and shocks.

*Source: Chapter 1 and Annex I, "Monetary Policy, FXI, and the Impact of CFMs" (wpiea2020288-print-pdf).*

### 1. Monetary Policy, FXI, and the Impact of CFMs ........................................................................

### 1. Monetary Policy, FXI, and the Impact of CFMs

### Chapter scope and structure
- Presents analysis on the interaction among monetary policy, foreign exchange intervention (FXI), and capital flow management measures (CFMs).
- Included components listed for the chapter:
  - Main chapter pages: 29–35 (Chapter header indicates start at page 29; sections continue through IV. Conclusion on page 35).
  - Box: III.1. The Impact of Interest Rate Policy in the Face of External Pressure (page 28).
  - Annex I. Monetary Policy, FXI, and the Impact of CFMs (page 36).

### Empirical and analytical elements (figures and tables included in the chapter)
- Tables:
  - III.1. Correlations Between Use of Different Policy Tools
  - III.2. Liquidity Conditions in the FX Market Around the December 16, 2014 Hike in the Key Policy Rate
- Figures:
  - III.1. The Use of Additional Instruments
  - III.2. The Effect of a Monetary Policy Shock
  - III.3. IRF of Inflation to the NEER
  - III.4. IRF of Output and Inflation to Credit
  - III.5. Additional Policy Tools Delay the Monetary Policy Response to Credit and Exchange Rate Gaps
  - III.6. Impact of an External Financing Shock
  - III.7. Impact of a Domestic Demand Shock
  - III.8. The Policy Trade-off between Inflation and Output Volatility
  - III.9a Monetary Policy Rule: Unconstrained Taylor Rule
  - Figure III.9b. Monetary Policy Rule: Max (0, Unconstrained Taylor Rule)
- Related figures from earlier sections (contextual, cross-referenced):
  - II.1. External Factors, Growth, and Inflation
  - II.2. External Factors and the NEER
  - II.3. The Drivers of the Policy Rate
  - II.4. External Financial Conditions and the Policy Rate
  - II.5. The Response of Policy Rates to the FFR and Other Policy Tools
  - II.6. External Conditions and Long-term Financial Conditions
- Impulse response analysis is used (IRF references in figures III.2, III.3, III.4).
- The chapter examines specific episodes, including liquidity conditions around the December 16, 2014 hike in the key policy rate (Table III.2).

### Thematic emphasis (as indicated by titles and structure)
- Interaction among monetary policy, FXI, and CFMs under external financial pressures.
- Role and coordination of additional instruments (CFMs, macroprudential measures, FXI) in influencing the timing and effectiveness of monetary policy responses to exchange rate, credit, and external financing shocks.
- Trade-offs between inflation and output volatility under different policy configurations.
- Use of empirical tools (correlations, liquidity measures, impulse response functions) to assess policy impacts.
- Consideration of constrained monetary policy environments (cross-reference to "Monetary, Fiscal, and Macroprudential Policies, when Monetary Policy is Constrained" beginning page 32).

### Glossary terms used in the chapter (selected)
- AE Advanced Economy
- CFM Capital Flow Management Measures
- FX Foreign Exchange
- FXI Foreign Exchange Intervention
- IRF Impulse Response Function
- MPM Macroprudential Measure
- NEER Nominal Effective Exchange Rate
- NRE Non-reserve-issuing Economies
- ZLB Zero Lower Bound

*Source: Chapter 1, "Monetary Policy, FXI, and the Impact of CFMs" from the provided PDF content.*

### INTRODUCTION

### INTRODUCTION

### Overview
- Globalization produced benefits but also size and volatility of capital flows that posed policy challenges for small financially integrated non-reserve issuing economies (NREs).
- The global financial crisis (GFC) led systemic economies to undertake unprecedented measures that produced abrupt swings in risk sentiment, volatility in financing conditions, and large movements in capital flows, generating periods of pressure on NREs and raising concerns about economic and financial stability.
- The paper examines how changes in external financial conditions affect policy independence in two ways: (i) the effect on the policy rate chosen by policymakers; and (ii) the direct impact on domestic financial conditions (irrespective of policy rate changes).

### Empirical approach and samples
- Pooled panel structural VAR using monthly data from 2000 to 2016 for eleven emerging markets: Brazil, Chile, India, Indonesia, Malaysia, Mexico, Peru, Poland, Thailand, Turkey, and South Africa.
  - Model variables: external financial and real factors, growth, inflation, the nominal effective exchange rate (NEER), the policy rate, long-term interest rates, and domestic credit.
  - External financial conditions include country-specific EMBI and CDS spreads, US term premia, VIX. External real factors include external demand, terms of trade, and relevant commodity prices.
  - Baseline ordering (Cholesky): external financial conditions, external real conditions, domestic activity, CPI inflation, private credit growth, the policy rate, long-run yields, and the NEER.
- Local projection estimates using a sample of 66 NREs during 1996Q1 to 2015Q4 to estimate dynamic responses of monetary policy to global financial shocks (GFS approximated by Federal Funds Rates and the VIX).
- Panel regression (augmented Taylor rules) for a sample of 79 countries over 2000–2013 (49 emerging markets and developing countries included) to assess interactions between monetary policy and other tools (MPMs, CFMs, FXI).

### NREs’ vulnerability to spillovers (key findings)
- Real and financial external shocks are the largest individual drivers of volatility in small financially integrated NREs.
- External financial conditions contribute most to movements in domestic yields and the exchange rate, constraining monetary policy independence.
- External real factors are most important for other macroeconomic variables (growth and inflation).
- Exchange rate flexibility moderates the impact of external shocks; flexible regimes and deployment of targeted instruments help regain some monetary policy autonomy.
- In the 11-country VAR sample, domestic policy rates react directly to both external financial conditions and external real factors; domestic yields and exchange rates show high sensitivity to external financial shocks irrespective of domestic policy rate changes, suggesting loss of monetary policy independence.

### Transmission and effectiveness of policy instruments (key findings)
- Interest rate-based monetary policy in the 11 major EMEs effectively influences both output and inflation and transmits through long-term interest rates.
- Exchange rate flexibility is a critical buffer for NREs.
- Foreign exchange intervention (FXI) can mitigate appreciation and depreciation pressures mostly in the short run, with significant impact on the pace of FX when reserves are adequate and macroeconomic imbalances small.
- FXI impact is larger for countries with CFMs as CFMs reduce offsetting private capital flows.
- During periods of high external pressure, interest rate policy can be helpful.
- Panel regression for 79 NREs indicates central banks tend de facto to respond to financial and external stability considerations (exchange rate and credit channels).
- Use of alternative instruments targeted at financial or external stability objectives seems to limit the need for central banks to use monetary policy for those considerations.

### Effectiveness of policy packages and interactions
- Important interactions exist between policy instruments; the overall impact of a policy package depends on the nature of the shock and constraints on monetary policy transmission.
- In the case of the lower bound on monetary policy, an open-economy DSGE model indicates that a combined policy response to a global supply shock that lowers inflation can be more effective than a single-instrument response.
- Empirical evidence and literature cited (Basu et al. (2020); Adrian et al. (2020); Fayad and Poirson (2020); Finger and Lopez Murphy (2019); Gelos et al. (2019); Brandao-Marques et al. (2020)) illustrate progress on integrated policy frameworks and quantification of policy tradeoffs.

### Role of other policy measures in shaping monetary response
- Policy rates in NREs react to Fed policy rate changes: increases in the US policy rate raise domestic policy rates; the speed and magnitude differ by exchange rate regime and country-specific factors.
  - For fixed exchange rate regimes, policy rates react immediately.
  - For inflation-targeting countries with a floating exchange rate regime, impact becomes statistically significant after two quarters.
  - For countries with intermediate exchange rate regimes, impact becomes statistically significant after four quarters.
- An increase in the VIX leads to a reduction in NRE policy rates; for flexible regimes the response to VIX shocks becomes statistically significant 7 quarters after the shock, while for fixed regimes it is statistically significant for all quarters.
- Use of MPMs and CFMs softens the monetary policy response in countries with more flexible exchange rate regimes:
  - CFMs have significant short-run impact (first 3 quarters).
  - MPMs are generally less significant but longer-lasting.
- Changes in external conditions, especially tighter financial conditions, significantly raise longer-term bond yields independent of policy rate changes (suggesting loss of monetary policy independence).

### Use and effectiveness of additional instruments
- Increased use of CFMs, MPMs, and FXI has complemented macroeconomic policies, especially during tightening episodes.
- CFMs were an important part of the response to the 2009–12 capital inflow surge; CFMs on outflows were helpful in some crises.
- MPMs—e.g., loan-to-value and debt-to-income ratios—are used to limit systemic risks and procyclicality; empirical evidence on which policies most effectively reduce credit growth across sectors remains elusive.
- Net reserve accumulation slowed in many regions during 2009–15 as reserves were used to manage outflow episodes; increased two-sided intervention since the GFC, but not all countries used intervention freely.

### Empirical assessment of FX intervention (method and findings)
- Two-stage regressions (country-by-country) used to address endogeneity: first stage estimates central bank FX intervention reaction function (depends on recent exchange rate moves and volatility, reserves, exchange rate misalignment); second stage models exchange rate as function of short-term interest rates, longer-term spreads, commodity prices, VIX, and predicted intervention; interaction terms assess CFMs and MPMs effects.
- Findings:
  - Selling foreign reserves is effective at absorbing depreciation pressures.
  - Buying foreign reserves significantly moderates appreciation pressures, particularly when reserves are adequate, capital flows are restricted, inflation is well anchored, the exchange rate is not overvalued, macroeconomic imbalances are limited, and financial markets are less developed.
  - FXI significantly influences the pace of exchange rate changes but the paper does not find a statistically significant impact on the exchange rate level.
  - When CFMs are in place, selling FX intervention has a larger impact on stemming depreciation pressures.
- Non-spot FXI (limited experience) appears similarly effective in available cases and likely works via portfolio and signaling channels.

### Credit, MPMs, and business cycle implications
- Credit growth significantly affects inflation and real economic conditions; inflation and real activity respond strongly to credit growth.
- Quantity-based tools (e.g., reserve requirements) have been traditionally used by many NREs because of credit channel importance.
- Tightening MPMs significantly lowers the reaction of policy rates to credit gaps; tightening CFMs or use of FXI reduces the monetary policy reaction to exchange rate gaps.
- Panel evidence suggests additional tools delay and dampen monetary policy responses to credit and exchange rate gaps.

### Case study: Russia (2014–2015)
- Russia faced two adverse shocks in 2014: a drop in oil price and sudden closure of access to international capital markets due to sanctions, resulting in large net capital outflows, currency depreciation, and inflationary pressures.
  - Currency depreciation: 95 percent over the course of the year (2014).
- On December 16, 2014 the Central Bank of Russia (CBR) raised the policy rate by 650 basis points to 17 percent to anchor inflation expectations and reduce depreciation expectations; this followed a 100 bps increase on December 11, 2014 and introduction of repo transactions to normalize FX liquidity.
- Outcome and complementary measures:
  - Liquidity conditions in the FX market tightened upon the policy announcement but then began to normalize.
  - Complementary measures included temporary forbearance on loan classification, provisioning, and valuation accounting; expansion of collateral acceptable for FX repo auctions; temporary easing of restrictions in banks’ lending and deposit interest rates; and expanded FX liquidity provision to banks.
  - The key policy rate was lowered by 200 basis points on January 31, 2015, and by July 2015 the interest rate returned to the level prior to the December 16, 2014 hike.
- Box findings:
  - Trading volumes increased substantially following the CBR interest rate hike.
  - Liquidity conditions tightened as the market became one-sided amid market rumors (box continues beyond provided excerpt).

### Policy implications and research directions
- External conditions materially constrain policy independence in NREs through exchange rate, credit, and interest rate channels.
- Alternative, more targeted instruments (FXI, MPMs, CFMs) can be complementary to traditional macroeconomic policy tools and can reduce the need for monetary policy to lean against external or financial shocks.
- Effectiveness of combinations depends on shock type, transmission strength, policy constraints (including interest rate lower bound), initial conditions, stage of financial cycle, macroeconomic imbalances, costs and unintended consequences of tools, and adequacy of reserves.
- The paper suggests further policy research (including country-level analysis) on optimal instrument mixes and integrated policy frameworks.

*Italicized source: IMF working paper chapter "INTRODUCTION" (wpiea2020288-print-pdf - INTRODUCTION).*

### introduction of capital controls and political criticism against the CBR. Bid-ask spreads

### introduction of capital controls and political criticism against the CBR. Bid-ask spreads

### Liquidity and market microstructure around the December 16, 2014 policy event
- Bid-ask spreads increased by more than 617 percent relative to their average level during the week prior to the CBR’s announcement.
- The effective cost of transactions increased by 640 percent over the same period and liquidity strains remained in place for a few days before normalizing.
- The impact of trading on the price (exchange rate) increased: the impact of order flows on exchange rate returns increased significantly following the CBR’s interest rate hike and remained high before normalizing the week after the policy event.
- The return reversal (speed with which the exchange rate return converges to fundamentals) recovered to its normal dynamics (as indicated by the negative coefficient in Table V.1).

- Table III.2. Liquidity Conditions in the FX Market Around the December 16, 2014 Hike in the Key Policy Rate (values as reported)
  - Bid-Ask Spread (bps):
    - Week before Dec. 16: 14.38
    - Dec. 16: 88.85
    - Dec. 17: 242.91
    - Week after Dec. 17: 64.44
    - Memo: Full Sample⅟: 10.03
  - Effective cost of transaction (bps):
    - Week before Dec. 16: 1.65
    - Dec. 16: 10.56
    - Dec. 17: 14.44
    - Week after Dec. 17: 14.60
    - Memo: Full Sample⅟: 1.06
  - Price Impact (bps):
    - Week before Dec. 16: 2.50
    - Dec. 16: 13.56
    - Dec. 17: 13.56
    - Week after Dec. 17: -0.42
    - Memo: Full Sample⅟: 0.80
  - (Additional table rows)
    - Row with values: 4.29, -3.63, -21.76, -12.61, 0.42
    - Traded Volume (index):
      - Week before Dec. 16: 89.01
      - Dec. 16: 130.82
      - Dec. 17: 72.59
      - Week after Dec. 17: 36.78
      - Memo: Full Sample⅟: 101.95

- Source data indicated: EBS; and Author’s calculations (For definitions see text).

### The impact and effectiveness of policy packages — overview
- Key conclusions:
  - Effectiveness of a policy package is highly dependent on the type of shock and constraints on monetary policy transmission such as the effective lower bound (ELB).
  - Monetary policy can transmit through long-term interest rates.
  - Exchange rate flexibility plays a critical role as a buffer.
  - The credit channel remains effective in many NREs.
  - Important interactions exist between policy instruments which affect the impact of an overall package.
- The analysis compares:
  - A policy package (monetary policy plus additional tools) versus a simpler response relying on monetary policy and complete exchange rate flexibility.
  - Part 1: additional tools of FXI and CFMs.
  - Part 2: monetary policy with MPMs aimed at reducing systemic risks from foreign currency loans, including when monetary policy faces the ELB.

### 1. Monetary Policy, FXI, and the Impact of CFMs
- Modeling setup:
  - Stylized New Keynesian small open economy model (based on Escudé (2013)).
  - Two policy regimes compared:
    - Pure float (central bank follows only a Taylor rule).
    - Managed float (interest rate policy based on a Taylor rule plus FX intervention rule).
  - Two temporary macroeconomic shocks considered:
    - (i) external financial conditions shock (modeled as a risk premium shock);
    - (ii) domestic demand shock.
- Findings for a tighter external financial conditions shock:
  - Introduction of FXI ensures the interest rate is less responsive to a rise in the cost of foreign funds.
  - Without FXI: a rise in the risk premium leads to currency depreciation → higher CPI inflation via import prices → central bank raises policy rates.
  - With FXI: FXI reduces rate of depreciation → lowers impact on inflation → results in a lower domestic rate hike to achieve domestic inflation, output and employment objectives.
  - FXI can help manage extreme external pressure, especially if the country has substantial exchange rate pass-through or currency mismatches.
- Findings for a domestic demand shock:
  - FXI tends to shorten the duration of higher inflation and the required policy rate hike.
  - Immediately after the shock there is little difference across regimes, but subsequently FXI limits exchange rate depreciation and keeps inflation and policy rates somewhat lower than without FXI.
  - Cost: a more prolonged current account deficit and lower output.
  - Smoothing effect of FXI is significantly lower for a domestic demand shock than for an external financing shock.
- Policy trade-offs:
  - Combination of FXI and interest rate policy alters policymakers’ trade-offs between inflation and output volatility.
  - For external financing shocks, the two-policy regime is generally superior to a pure float (lower output and inflation volatility obtainable).
  - For domestic demand shocks, central bank faces a trade-off between inflation and output-gap stabilization.
- Role of CFMs:
  - Existence of CFMs would likely result in a smaller response through interest rate policy and FX intervention.
  - CFMs limit the extent of capital flows for any given external shock and reduce their sensitivity to interest rate movements.
  - CFMs enhance the effectiveness of intervention; the impact of external financial conditions shock would be smaller and the responses of policy rates and FXI would be smaller than in absence of CFMs.
  - For demand shocks, CFMs mitigate the exchange rate impact but do not materially change the main elements of the policy package.

### 2. Monetary, Fiscal, and Macroprudential Policies when Monetary Policy is Constrained
- Scope:
  - Interaction between monetary, fiscal, and macroprudential policies in response to external shocks.
  - Focus on constraints such as a lower bound on policy rates (ELB).
- Modeling evidence:
  - Open-economy DSGE models are limited; Chen and Laseen (2017) develop a model investigating interactions in the context of high foreign currency borrowing.
  - Lower bound constraints modeled as an exogenous constraint (fixed level of interest rate); special case considered where lower bound fixed at zero.
- Additional policy tools considered:
  - Fiscal authority can raise taxes to finance expenditures.
  - Macroprudential authority can set a variable levy on foreign borrowing to mitigate systemic financial sector risks from build-up of excessive foreign currency exposures (this measure can be considered both a CFM and an MPM).
- Main results:
  - Having a macroprudential policy instrument is more beneficial than a single instrument (interest rate) response.
  - In a global supply shock that lowers inflation:
    - Monetary policy raises inflation faster when the macroprudential instrument is activated (than when absent).
    - Policy interest rate does not need to be lowered as much where macroprudential policy is activated.
    - Main channel: exchange rate depreciation induced by higher levy on firms’ foreign borrowing reduces foreign credit and weakens appreciation pressure.
  - Fiscal policy combined with monetary policy also helps raise inflation faster, via different transmission channels.
  - Gains from macroprudential policy are significantly larger when monetary policy is constrained:
    - When monetary policy is constrained by the ELB, the macroprudential instrument helps raise inflation much faster toward the target, allowing the policy rate to leave the lower bound earlier.
    - Fiscal multipliers are higher at the ELB.
- Mechanism and externality:
  - When monetary policy hits the ELB, domestic bank credit becomes relatively more expensive than foreign credit → firms choose to borrow relatively more abroad.
  - This generates an externality: higher capital inflows create additional appreciation pressure which firms do not internalize.
  - Macroprudential policy reduces this externality by making foreign credit more expensive relative to domestic funding → firms borrow less abroad → reduces appreciation pressure from the lower bound on interest rates.
  - Fiscal policy carries a larger multiplier at the ELB because the nominal interest rate is not raised (“fixed” at the ELB) in response to increased government spending.

### Conclusion — policy implications and open questions
- NREs have broadened their policy toolkit over the past 15 years to include greater exchange rate flexibility, MPMs, FXI, and to a more limited degree CFMs.
- In response to COVID-19 shocks, EMs have allowed exchange rates to play a large shock absorber role while use of CFMs has been limited so far.
- Policy interactions matter: the paper provides direct measures of quantitative implications of interactions for monetary policy independence, monetary policy response, and FXI effectiveness, and an assessment of policy mix effectiveness and transmission.
- Findings:
  - Growing financial integration makes NREs susceptible to global financial spillovers.
  - External real and financial shocks affect domestic real and financial conditions, policy transmission to long-term rates, and the monetary policy reaction.
  - Dependence of monetary policy on international spillovers and its response to non-traditional objectives is attenuated in countries using FXI and/or activating other tools (MPMs and CFMs).
  - FXI can reduce exchange rate volatility and is more effective with CFMs under some circumstances.
  - Combined-instrument responses can sometimes be more effective than single-instrument responses; effectiveness depends on shock type.
  - FXI helps smooth external financing shocks but adds relatively little for domestic demand or supply shocks.
  - Well-targeted MPMs combined with monetary policy are more effective at stabilizing inflation and output in a global disinflationary shock, particularly when monetary policy faces constraints such as a ZLB.
- Suggested further work:
  - Explore effectiveness of alternative policies in softening monetary policy response to other global financial shocks besides US monetary policy shocks.
  - Study other interactions between instruments (CFMs/MPMs, FXI/MPMs, fiscal policy and unconventional tools including UMP).
  - Apply more granular, country-level examinations given specifics of policy transmission and shocks.

*Source: wpiea2020288-print-pdf - introduction of capital controls and political criticism against the CBR. Bid-ask spreads*

### Annex I. Monetary Policy, FXI, and the Impact of CFMs

### Annex I. Monetary Policy, FXI, and the Impact of CFMs

### Model overview
- Framework: Standard new Keynesian small open economy model following Escudé (2013) (Dynare code by the author).
- Agents and markets:
  - Households consume domestic and imported goods and hold financial wealth in domestic bonds issued by the central bank (CB) and foreign-currency bonds (foreign borrowing). Asset markets are incomplete.
  - Firms produce domestic goods and exports; price setting is staggered à la Calvo (1983). Export good treated as a primary good (commodity).
  - Central bank issues currency (M_t), domestic bonds (B_t), and holds international reserves (R_t) in the form of foreign-currency risk-free bonds.
- International borrowing rate: international risk-free rate i_t^* augmented by an endogenous risk premium that depends on aggregate foreign debt-to-GDP.

### Modelling risk premium
- Borrowing rate definition (textual form preserved):
  - 1 + i_t^DD = (1 + i_t^*)^{φ^*} τ_D (G_t D_t / P_t Y_t)
- Definitions and roles:
  - G_t: nominal exchange rate (domestic/foreign currency)
  - D_t: foreign debt
  - P_t Y_t: nominal GDP
  - φ^*: exogenous stochastic component capturing shocks to international liquidity
  - τ_D(·): gross risk premium, an increasing function of foreign debt-to-GDP (debt-elastic interest rate à la Schmitt-Grohe and Uribe 2003) ensuring stationarity

### Monetary policy: instruments, CB constraint, and operational rules
- Central bank balance sheet and flow constraint (textual form preserved):
  - CB issues currency M_t, domestic bonds B_t, and holds international reserves R_t.
  - Profits from interest and capital gains on reserves are assumed transferred to the government every period, making central bank net worth constant.
  - Flow budget constraint (textual): M_t + B_t − G_t R_t = M_{t-1} + (1 + i_{t-1}) B_{t-1} − (1 + i_{t-1}^*) G_t R_{t-1}
  - Stylized CB constraint for sterilization of FX intervention: M_t + B_t − G_t R_t = 0
- Quasi-fiscal costs:
  - Interest income and capital gains from FX reserves transferred to government each period (quasi-fiscal); costs of sterilized FX intervention linked to carry costs and exchange-rate-induced capital positions.

a. Taylor rule (textual form preserved)
- Rule specification:
  - 1 + i_t / 1 + i = ( (1 + i_{t-1}) / (1 + i) )^{h0} (π_t / π_T)^{h1} (Y_t / Y)^{h2} (e_t / e)^{h3}
- Interpretations:
  - h0: interest-rate inertia
  - h1: weight on deviations from target inflation
  - h2: weight on steady-state output deviations
  - h3: weight on real exchange rate deviations

b. Intervention policy (second operational target)
- Operational target: rate of nominal depreciation δ_t; instrument is buying/selling FX reserves.
- Intervention rule (textual form preserved):
  - δ_t / δ = (δ_{t-1} / δ)^{k0} (π_t / π_T)^{k1} (Y_t / Y)^{k2} (e_t / e)^{k3} (e_t r_t / Y_t)^{k4}
- Baseline assumptions for benchmark:
  - k0=k1=k2=k3=0; coefficient on foreign reserves k4 is negative—an increase in international reserves lowers the rate of depreciation (and vice versa).
- Role in analysis:
  - Introduce a second rule (intervention) to study how augmenting interest-rate policy with exchange-rate management alters responses to shocks and volatility trade-offs between CPI inflation and output.

### Benchmark parameterization used in simulations
- h0=0.2; h1=1.2; h2=0.02; h3=0; k0=k1=k2=k3=0; k4=-0.005

### Optimal simple rules and loss function
- Policy objective: central bank minimizes a quadratic loss function L that is a weighted sum of volatilities:
  - L = w_π Var_qr(π) + w_y Var_qr(y) + w_{Δi} Var(Δi) + w_{Δδ} Var_qr(Δδ)
- Regime-specific decision variables:
  - Pure float regime: choose h0, h1, h2, h3 (Taylor rule parameters).
  - Managed float regime: choose h0, h1, h2 (Taylor rule parameters) and k4 (intervention rule parameter), focusing on interventions that target the rate of depreciation with k1=k2=k3=0 for simplicity.
- Purpose of comparison:
  - Evaluate how adding an FX-reserve-based intervention instrument (k4) impacts stabilization trade-offs (inflation vs. output volatility) and optimal policy parameter choices.

*Italic source: Annex I. Monetary Policy, FXI, and the Impact of CFMs (wpiea2020288-print-pdf) — IMF working paper content provided.*

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_Source: https://www.imf.org/-/media/files/publications/wp/2020/english/wpiea2020288-print-pdf.pdf_