Shocks Matter: Managing Capital Flows with Multiple Instruments in Emerging Economies
IMF Working Papers, June 19, 2020
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Bibliographic details
- Authors: Ruy Lama, Juan Pablo Medina
- Published: June 19, 2020
- Series: IMF Working Papers
Overview and research question
- Study setting: small open economy model with financial frictions and multiple policy instruments.
- Objective: identify optimal management of capital flows using combinations of monetary policy rate, foreign exchange intervention (FXI), and macroprudential policy.
Main findings
- Both foreign exchange intervention (FXI) and macroprudential policies are complementary to the monetary policy rate and can largely reduce inflation and output volatility in a scenario of capital outflows.
- The optimal policy mix depends on the underlying shock driving capital flows:
- FXI plays the leading role in response to foreign interest rate shocks.
- Macroprudential policy becomes the prominent tool for domestic risk shocks.
- Policy implication: calibrate the use of multiple instruments according to the underlying shocks that induce shifts in capital flows.
Policy recommendations and practical implications
- Use FXI as the primary adjustment mechanism when capital flow shifts are driven by foreign interest rate movements.
- Emphasize macroprudential tightening when capital flow shifts are driven by increases in domestic risk.
- Coordinate instruments—monetary policy rate, FXI, and macroprudential tools—to reduce inflation and output volatility under capital outflow scenarios.
- Calibrate instrument intensity and sequencing based on identified shock type to improve stabilization outcomes.
Source: IMF Working Paper "Shocks Matter: Managing Capital Flows with Multiple Instruments in Emerging Economies", Ruy Lama and Juan Pablo Medina, June 19, 2020.
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