Optimal Monetary Policy and Capital Account Restrictions in a Small Open Economy

Zheng Liu and Mark Spiegel

No 2013-33, Working Paper Series from Federal Reserve Bank of San Francisco

Abstract: The recent financial crisis has led to large declines in world interest rates and surges of capital flows to emerging market economies. We examine the effectiveness and welfare implications of capital control policies in the face of such external shocks in a monetary DSGE model of a small open economy. We consider both optimal, time-varying restrictions on capital inflows and a simple capital account restriction, such as a constant tax on foreign debt holdings. We then compare the effectiveness of such capital account restrictions under alternative monetary regimes. We find that the optimal time-varying capital control policy is very effective in mitigating foreign interest rate shocks, but less effective for insulating the economy from export demand shocks; in the presence of export demand shocks, an exchange-rate stabilizing monetary policy regime can enhance macroeconomic stability and improve welfare. Under a simple and more practical capital control policy, a monetary policy regime that places larger weight on inflation fluctuations leads to additional gains in macroeconomic stability, although an exchange-rate stabilizing regime leads to even greater gains. Our findings suggest that, with either type of capital control policies, stabilizing the real exchange rate is a robust and effective monetary policy to help weather external shocks.

JEL-codes: E42 F31 F32 (search for similar items in EconPapers)
Pages: 35 pages
Date: 2013
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac, nep-mon and nep-opm
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Citations: View citations in EconPapers (11)

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Journal Article: Optimal Monetary Policy and Capital Account Restrictions in a Small Open Economy (2015)
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedfwp:2013-33

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DOI: 10.24148/wp2013-33

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