Toward an Integrated Policy Framework for Open Economies
IMF Blog, July 13, 2020
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Bibliographic details
- Authors: Tobias Adrian, Gita Gopinath
- Published: July 13, 2020
Overview
- Authors: Tobias Adrian, Gita Gopinath
- Date: July 13, 2020
- Core premise: Capital mobility benefits economies but capital flows to emerging market and developing economies are often volatile and depend critically on global financial conditions.
- Motivation: Conventional monetary policy tools can be insufficient to address risks from volatile capital flows; policymakers increasingly combine interest rate policy with foreign exchange intervention, capital flow measures, and macroprudential actions.
- IMF objective: Use conceptual and quantitative models to guide integrated use of policy tools, explicitly accounting for frictions (dominant currency pricing, currency mismatch on balance sheets, foreign investors' limited appetite for emerging markets’ local currency debt, poorly anchored inflation expectations) and both domestic and external shocks.
Conceptual Model for the Integrated Policy Framework — Key insights
- General goal: Analytically derive optimal policies as a function of country-specific frictions and shocks.
- Insight 1:
- If an additional policy instrument becomes available, it should not necessarily be deployed because it may not be the right tool to address the imperfection at hand.
- Example: With dominant currency pricing, flexible exchange rates remain optimal in the absence of other frictions; using foreign exchange intervention and capital flow measures can worsen outcomes because they do not address the pricing friction.
- Insight 2:
- When additional frictions exist—such as capital market imperfections associated with over-borrowing—dominant currency pricing can increase the need for exchange interventions, capital flow measures, and macroprudential measures.
- Mechanism: Private agents tend to overborrow in foreign currency because they do not internalize future market stress when foreign lending conditions tighten, currencies depreciate, and balance sheets weaken.
- Policy implication: Prudential capital inflow controls can mitigate overborrowing in good times and excessive deleveraging in bad times; greater need for prudential inflow controls in countries with dominant currency pricing because the exchange rate is less effective in stabilizing demand.
- Insight 3:
- Flexible exchange rates do not necessarily preserve monetary policy independence (a departure from the classic trilemma).
- Episode example: The taper tantrum in 2013 can sharply raise premia demanded by foreign investors for local currency debt, pressuring monetary policy to raise policy rates and tighten domestic financial conditions.
- Policy implication: Using exchange intervention and prudential policies to address external shocks can free the domestic policy rate to focus on domestic price pressures.
A Quantitative Model for the Integrated Policy Framework — Key findings
- Model framework: An open economy New Keynesian model embedding complex, nonlinear balance sheet channels and a range of frictions to capture empirical features of financial stress episodes (including domestic credit conditions tightening when the exchange rate depreciates).
- New form of loss of monetary policy independence:
- Arises when inflation expectations are poorly anchored (common in some emerging and developing economies).
- Tradeoff: Central banks face a choice between sharply raising interest rates to keep inflation stable—at the cost of a steep output decline—and pursuing a more passive policy that risks allowing inflation to become unmoored.
- Role of integrated policies:
- Foreign exchange intervention and capital controls can improve policy tradeoffs under certain conditions, especially for economies with:
- less well-anchored inflation expectations,
- a high sensitivity of domestic borrowing conditions to the exchange rate,
- greater vulnerability to shocks that cause capital outflow and exchange rate pressures.
- Notable outcome: Integrated policies may reduce downside risks to output associated with shocks that resemble a sudden stop.
Policy implications and recommendations
- Do not assume new instruments should always be used; match instruments to specific frictions and shocks.
- Prioritize understanding country-specific frictions: dominant currency pricing, capital market imperfections, balance sheet currency mismatches, and the anchoring of inflation expectations.
- Consider prudential capital inflow controls to address tendencies toward foreign currency overborrowing and to mitigate procyclical deleveraging.
- Use exchange intervention and prudential measures to manage external shocks so monetary policy can concentrate on domestic price stability when appropriate.
- Recognize integrated policies can improve tradeoffs in economies with poorly anchored inflation expectations or strong balance sheet/exchange rate linkages.
Ongoing work and next steps
- Complementary streams: Extensive empirical work and country case studies testing impacts and trade-offs of various tools; exploring unintentional consequences of unconventional tools on foreign currency exposure and financial market developments; addressing communication challenges when multiple instruments are used.
- Policy process: Combined work to be discussed by the IMF’s Executive Board in the fall to provide guidance for policymakers on deploying multiple tools with attention to shock type, specific frictions, pre-existing conditions, and practical considerations.
Source: Toward an Integrated Policy Framework for Open Economies (Tobias Adrian, Gita Gopinath), July 13, 2020