Monetary Policy Divergence and Net Capital Flows: Accounting for Endogenous Policy Responses

36 Pages Posted: 24 Jan 2019 Last revised: 21 Feb 2019

See all articles by Scott Davis

Scott Davis

Federal Reserve Banks - Federal Reserve Bank of Dallas

Andrei Zlate

Federal Reserve Banks - Federal Reserve Bank of Boston

Date Written: 2018-09-27

Abstract

This paper measures the effect of monetary tightening in key advanced economies on net capital flows around the world. Measuring this effect is complicated by the fact that the domestic monetary policies of affected economies respond endogenously to the foreign tightening shock. Using a structural VAR framework with quarterly panel data we estimate the impulse responses of domestic policy variables and net capital flows to a foreign monetary tightening shock. We find that the endogenous response of domestic monetary policy depends on each economy's capital account openness and exchange rate regime. We use a method to compute counterfactual impulse responses for net capital outflows under the assumption that the domestic policy rate does not respond to foreign monetary tightening. Our results suggests that failing to account for the endogenous response of domestic monetary policy biases down the estimated elasticity of net capital flows to foreign interest rates by as much as one-third for countries with open capital accounts.

Keywords: trilemma, structural VAR, counterfactual VAR, net capital inflows, exchange rates

JEL Classification: E5, F3, F4

Suggested Citation

Davis, Scott and Zlate, Andrei, Monetary Policy Divergence and Net Capital Flows: Accounting for Endogenous Policy Responses (2018-09-27). FRB Boston Risk and Policy Analysis Unit Paper No. RPA 18-5. Available at SSRN: https://ssrn.com/abstract=3321605

Scott Davis (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Dallas ( email )

2200 North Pearl Street
PO Box 655906
Dallas, TX 75265-5906
United States

Andrei Zlate

Federal Reserve Banks - Federal Reserve Bank of Boston ( email )

600 Atlantic Avenue
Boston, MA 02210
United States

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