One Shock, Many Policy Responses

IMF Working Papers, January 17, 2020

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Policymakers have relied on a wide range of policy tools to cope with capital flow shocks.
Quantile local projections are used to estimate the entire distribution of future policy responses to portfolio flow shocks for 20 emerging markets and understand the variety of policy choices across the sample.
To assuage endogeneity concerns, estimates rely on the fact that global capital flows are exogenous from the viewpoint of any one of these countries.
The paper finds that:
- (i) policy responses to capital flow shocks are heterogeneous across countries, fat-tailed—“extreme” responses tend to be more elastic than “typical” responses—and asymmetric—“extreme” responses tend to be more elastic with respect to outflows than to inflows;
- (ii) country characteristics are linked to policy choices—with cross-country differences in forex intervention relating to the size of balance sheet vulnerabilities and the depth of the forex market;
- (iii) the use of targeted macroprudential policy and capital flows management measures can help “free the hands” of monetary policy by allowing it to focus more squarely on domestic cyclical developments.

Empirical approach: quantile local projections to estimate the entire distribution of future policy responses to portfolio flow shocks.
Identification strategy: reliance on global capital flows being exogenous from the viewpoint of any single country in the 20-emerging-market sample.

Heterogeneous and fat-tailed policy responses imply that “extreme” episodes require different analytical attention than “typical” responses.
Asymmetry in responses (stronger elasticity to outflows than to inflows in extreme cases) suggests different policy priorities depending on shock direction.
Targeted macroprudential policies and capital flows management measures can complement monetary policy by reducing trade-offs and allowing monetary policy to target domestic cyclical objectives.

Subjects: Balance of payments, Capital flows, Central bank policy rate, Exchange rate adjustments, Exchange rates, Financial services, Foreign exchange
Keywords: Capital flows, capital flows management, Central bank policy rate, De-Facto exchange rate flexibility, emerging markets, Exchange rate adjustments, exchange rate response, Exchange rates, foreign exchange intervention, FX intervention, FX purchase, FX sale, Global, inflation-targeting monetary policy framework, macroprudential policies, WP