A Conceptual Model for the Integrated Policy Framework

IMF Working Papers, July 7, 2020

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Paper develops a model of optimal monetary policy, capital controls, foreign exchange intervention, and macroprudential policy.
Incorporates many shocks and allows countries to differ across:
- currency of trade invoicing,
- degree of currency mismatches,
- tightness of external and domestic borrowing constraints,
- depth of foreign exchange markets.
Maps shocks and country characteristics to optimal policies and derives guiding principles for instrument use.

In the Mundell-Fleming framework, standard monetary policy and exchange rate flexibility fully insulate economies from shocks; however, that framework abstracts from many real world imperfections.
Countries often resort to unconventional policies to cope with shocks, such as COVID-19.
If an additional instrument becomes available, it should not necessarily be deployed because it may not be the right tool to address the imperfection at hand.
The use of a new instrument can lead to more or less use of others as instruments interact in non-trivial ways.

Model integrates multiple policy instruments:
- monetary policy (central bank policy rate),
- capital controls,
- foreign exchange intervention (FX intervention),
- macroprudential policy (prudential tax, housing constraint considerations).
Country heterogeneity explicitly modeled across:
- currency of trade invoicing,
- degree of currency mismatches,
- tightness of external borrowing constraints,
- tightness of domestic borrowing constraints,
- depth of foreign exchange markets.

Instrument selection should be guided by the specific imperfection or shock; availability alone is not sufficient reason for deployment.
Policymakers should account for interactions among instruments, since deploying one instrument may change optimal use of others.
Optimal policy design requires accounting for:
- exchange rate dynamics and exchange rate flexibility,
- currency markets and foreign exchange considerations,
- housing sector vulnerabilities and housing-related constraints,
- financial markets depth and structure.