Monetary Policies and Destabilizing Carry Trades Under Adaptive Learning

Abstract

This paper investigates how different monetary policy designs alter the effect of carry trades on a host small open economy. Capital inflows are expansionary, leading the central bank to raise the interest rate, increasing carry trades' returns, and generating further capital inflows (carry trades' vicious circle). This paper shows how monetary authorities can mitigate or suppress this vicious circle, when agents do not have full information about the central bank's objectives. The best way to deal with the destabilizing effect of carry trades is to target both inflation and capital inflows.

Keywords: Capital Inflows, Carry Trades, Interest Rate Differential, Vicious Circle, Inflation Targeting

JEL Classification: E44, E52, E58, F31, G15