Juan Pablo Medina, UAI

“Mundell meets Poole: Managing Capital Flows with Multiple Instruments in Emerging Economies”
Coautoreado con Ruy Lama

Abstract: We study the optimal management of capital flows in a small open economy model with financial frictions and multiple policy instruments (monetary policy rate, foreign exchange intervention, and reserve requirements). Two are the main results of the paper. First, both foreign exchange intervention (FXI) and reserve requirements are policy tools complementary to the monetary policy rate that can greatly reduce inflation and output volatility in a scenario of capital outflows. Second, the optimal policy mix depends on the underlying shock driving capital flows. FXI takes the leading role in response to foreign interest rate shocks, while reserve requirements become the prominent tool for domestic risk shocks. Moreover, these results blend the policy prescriptions of Mundell (1968), who stated that ”policies should be paired with the objectives on which they have the most influence” and Poole (1970), who showed that the optimal policy instrument ultimately depends on the shock hitting the economy.