A New Dilemma: Capital Controls and Monetary Policy in Sudden-Stop Economies

Michael Devereux, Eric Young and Changhua Yu

No 32016, Working Papers from Hong Kong Institute for Monetary Research

Abstract: The dangers of high capital flow volatility and sudden stops have led economists to promote the use of capital controls as an addition to monetary policy in emerging market economies. This paper studies the benefits of capital controls and monetary policy in an open economy with financial frictions, nominal rigidities, and sudden stops. We focus on a time-consistent policy equilibrium. We find that during a crisis, an optimal monetary policy should sharply diverge from price stability. Without commitment, policymakers will also tax capital inflows in a crisis. But this is not optimal from an ex-ante social welfare perspective. An outcome without capital inflow taxes, using optimal monetary policy alone to respond to crises, is superior in welfare terms, but not time-consistent. If policy commitment were in place, capital inflows would be subsidized during crises. We also show that an optimal policy will never involve macro-prudential capital inflow taxes, or a departure from price stability, as a precaution against the risk of future crises (whether or not commitment is available).

Keywords: Sudden stops; Pecuniary externality; Monetary policy; Capital controls; Time-consistency (search for similar items in EconPapers)
JEL-codes: E44 E58 F38 F41 (search for similar items in EconPapers)
Pages: 67 pages
Date: 2016-03
New Economics Papers: this item is included in nep-dge, nep-mac, nep-mon and nep-opm
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Related works:
Working Paper: A New Dilemma: Capital Controls and Monetary Policy in Sudden Stop Economies (2015)
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Persistent link: https://EconPapers.repec.org/RePEc:hkm:wpaper:032016

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