Macro-financial policies under a managed float: A simple integrated framework

Revised version published on 5 May 2023.

Summary

Focus

We study the performance of a range of macroeconomic policy tools under a managed float in a simple open economy with financial frictions. These tools include monetary policy, fiscal policy, foreign exchange intervention, macroprudential policy and capital controls. The impact of these policies are studied individually to highlight their transmission channels. However, we also study their impact in pairs in response to capital inflows induced by a reduction in world interest rates. This highlights the extent to which they complement each other.

Contribution

Some of the issues which we study have been addressed in relatively complex quantitative models. However, simple analytical policy tools which emphasise the role of financial frictions – a key feature of modern macroeconomics – are still missing. Our model is analytically tractable and can be used to study the impact of these policies. It therefore provides a useful entry point to the more advanced literature.

Findings

We find that whether monetary policy should be contractionary or expansionary, to stabilise the economy in response to capital inflows driven by external financial shocks, depends on which other instrument(s) policymakers have at their disposal. In particular, if fiscal policy is the only other instrument available, a reduction in the policy interest rate and a spending cut is effective. However, if the other available instrument is capital controls, an increase in the policy rate coupled with a tightening of capital controls is most effective to stabilise the economy. The fact that an effective policy mix may involve higher rather than lower interest rates, depending on the other instrument available, runs counter to standard policy prescriptions.

Abstract

This paper presents a simple integrated macroeconomic model of a small, bank-dependent open economy with a managed float and financial frictions. The model is used to study the effects of five types of policy instruments: fiscal policy, monetary policy, macroprudential regulation, foreign exchange intervention, and capital controls, in the form of a tax on bank foreign borrowing. It also considers how, following a drop in the world interest rate, these instruments can be combined to restore the initial equilibrium. The analysis illustrates how macro-financial policies can complement each other in response to capital inflows. In particular, it is shown that, to stabilize the economy, whether monetary policy should be contractionary (a common prescription in practice) or expansionary depends on which other instruments are available to policymakers. The joint use of macroprudential regulation and capital controls is also shown to provide a potent combination to manage capital inflows.

JEL classification: E63, F38, F41