Hasan Toprak (University of Virginia)

Title: The Composition of Capital Inflows and Optimal Monetary Policy in Sudden-Stop Economies

Abstract: Accounting for different types of capital flows, this paper studies whether monetary policy in emerging market economies should be prudential—i.e., deviate from price stability to induce agents to borrow less and hold more insurance during tranquil times. I develop a New Keynesian open economy model in which agents can trade a variety of international assets subject to a collateral constraint. I derive a set of theoretical results, then calibrate the model and conduct a quantitative analysis. I find that there is no scope for prudential monetary policy if either (1) the government can regulate both the level and composition of capital inflows or (2) commitment is not possible and the government can only regulate the volume but not the composition of flows. Otherwise, monetary policy should be prudential, though it is less effective than capital controls, especially without commitment. Compared with single bond setups, having multiple securities further reduces monetary policy’s capability to act in a prudential manner. These results suggest that macroprudential instruments that target both the level and composition of capital inflows are an essential part of an optimal policy mix. When capital controls are not available, committing to a simple inflation targeting rule delivers higher welfare than discretionary prudential monetary policy.

You can find the paper here.