Integrated Monetary and Financial Policies for Small Open Economies

77 Pages Posted: 22 Aug 2023

See all articles by Suman Sambha Basu

Suman Sambha Basu

International Monetary Fund (IMF)

Emine Boz

International Monetary Fund (IMF)

Gita Gopinath

International Monetary Fund (IMF); Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

Francisco Roch

International Monetary Fund (IMF)

Filiz Unsal

International Monetary Fund (IMF)

Abstract

We develop a tractable small-open-economy framework to characterize the constrained efficient use of the policy rate, foreign exchange (FX) intervention, capital controls, and domestic macroprudential measures. The model features dominant currency pricing, shallow FX markets, and occasionally-binding external and domestic borrowing constraints. We characterize the conditions for the “traditional prescription”—relying on the policy rate and exchange rate flexibility—to be sufficient, even if externalities persist. The conditions are satisfied for world interest rate shocks if FX markets are deep. By contrast, we show that to manage non-fundamental inflow surges and taper tantrums related to local currency debt, capital inflow taxes and FX intervention should be used instead of the policy rate and exchange rate flexibility. In the realistic case where countries face both shallow FX markets and external borrowing constraints, we establish that some kinds of FX mismatch regulations may reduce the external debt limit friction but worsen FX market depth. Finally, we show that capital controls and domestic macroprudential measures cease to be perfect substitutes if there is a risk that the domestic borrowing constraint binds as a result of the transmission of the global financial cycle.

Keywords: integrated policy framework, monetary policy, capital controls, foreign exchange intervention, macroprudential policies

JEL Classification: E58, F41, G28

Suggested Citation

Basu, Suman Sambha and Boz, Emine and Gopinath, Gita and Roch, Francisco and Unsal, Filiz, Integrated Monetary and Financial Policies for Small Open Economies. IMF Working Paper No. 2023/161, Available at SSRN: https://ssrn.com/abstract=4542090 or http://dx.doi.org/10.5089/9798400251931.001

Suman Sambha Basu (Contact Author)

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Emine Boz

International Monetary Fund (IMF) ( email )

Gita Gopinath

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Harvard University - Department of Economics ( email )

Littauer Center
Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Francisco Roch

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Filiz Unsal

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

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