Capital Flows and Financial Stability: Monetary Policy and Macroprudential Responses

August 1, 2011

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Format: Chicago

Filiz D Unsal. Capital Flows and Financial Stability: Monetary Policy and Macroprudential Responses, (USA: International Monetary Fund, 2011) accessed December 4, 2024

Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary

The resumption of capital flows to emerging market economies since mid 2009 has posed two sets of interrelated challenges for policymakers: (i) to prevent capital flows from exacerbating overheating pressures and consequent inflation, and (ii) to minimize the risk that prolonged periods of easy financing conditions will undermine financial stability. While conventional monetary policy maintains its role in counteracting the former, there are doubts that it is sufficient to guard against the risks of financial instability. In this context, there have been increased calls for the development of macroprudential measures, with an explicit focus on systemwide financial risks. Against this background, this paper analyses the interplay between monetary policy and macroprudential regulations in an open economy DSGE model with nominal and real frictions. The key result is that macroprudential measures can usefully complement monetary policy. Even under the "optimal policy," which calls for a rather aggressive monetary policy reaction to inflation, introducing macroprudential measures is found to be welfare improving. Broad macroprudential measures are shown to be more effective than those that discriminate against foreign liabilities (prudential capital controls). However, these measures are not a substitute for an appropriate moneraty policy reaction. Moreover, macroprudential measures are less useful in helping economic stability under a technology shock.

Subject: Balance of payments, Capital inflows, Financial sector policy and analysis, Labor, Macroprudential policy, Macroprudential policy instruments, National accounts, Return on investment, Self-employment

Keywords: Adjustment cost, Capital controls, Capital goods, Capital inflows, Cost difference, Credit growth, Emerging markets, Equilibrium mark-up, Financing costs decline, Global, Interest rate, Macroprudential policies, Macroprudential policy, Macroprudential policy instruments, Monetary policy, Nominal interest rate, Open economy, Price adjustment cost, Production firm, Return on investment, Self-employment, WP

Publication Details

Pages:

27
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2011/189
Stock No:

WPIEA2011189
ISBN:

9781462307272
ISSN:

1018-5941

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