Integrated Monetary and Financial Policies for Small Open Economies

IMF Working Papers, August 4, 2023

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Develops a tractable small-open-economy framework to characterize the constrained efficient use of:
- the policy rate,
- foreign exchange (FX) intervention,
- capital controls,
- domestic macroprudential measures.
Model features:
- dominant currency pricing,
- shallow FX markets,
- occasionally-binding external and domestic borrowing constraints.

Conditions for the “traditional prescription” (relying on the policy rate and exchange rate flexibility) to be sufficient are characterized, even if externalities persist.
The conditions for the traditional prescription are satisfied for world interest rate shocks if FX markets are deep.
For non-fundamental inflow surges and taper tantrums related to local currency debt:
- capital inflow taxes and FX intervention should be used instead of the policy rate and exchange rate flexibility.
In the realistic case where countries face both shallow FX markets and external borrowing constraints:
- some kinds of FX mismatch regulations may reduce the external debt limit friction but worsen FX market depth.
Capital controls and domestic macroprudential measures cease to be perfect substitutes if there is a risk that the domestic borrowing constraint binds as a result of the transmission of the global financial cycle.

When FX markets are deep and shocks are to world interest rates, relying on the policy rate and exchange rate flexibility can be sufficient even with persistent externalities.
For episodes driven by non-fundamental capital inflows or taper-tantrum dynamics tied to local-currency debt, prioritize capital inflow taxes and FX intervention over adjustments to the policy rate and exchange rate flexibility.
Be cautious with FX mismatch regulations: while they can alleviate external debt limit frictions, they may worsen FX market depth.
Recognize that capital controls and domestic macroprudential measures are not perfect substitutes in environments where the global financial cycle can trigger binding domestic borrowing constraints.

Integrated Monetary and Financial Policies for Small Open Economies, IMF Working Paper No. 2023/161