Managing Capital Flows in the Presence of External Risks

64 Pages Posted: 19 Sep 2017 Last revised: 29 Sep 2017

See all articles by Ricardo Reyes-Heroles

Ricardo Reyes-Heroles

Board of Governors of the Federal Reserve System

Gabriel Tenorio

Boston Consulting Group

Date Written: September, 2017

Abstract

We introduce external risks, in the form of shocks to the level and volatility of world interest rates, into a small open economy model subject to the risk of sudden stops?large recessions together with abrupt reversals in capital inflows| and characterize optimal macroprudential policy in response to these shocks. In the model, collateral constraints create a pecuniary externality that leads to \"overborrowing\" and sudden stops that arise when the constraints bind. The typical sudden stop generated by the model replicates existing empirical evidence for emerging market economies: Low and stable external interest rates reinforce \"overborrowing\" and lead to greater exposure to crises typically accompanied by abrupt increases in interest rates and a persistent rise in their volatility. We solve for the optimal policy and argue that the size of a tax on international borrowing that implements the policy depends on two factors, the incidence and the severity of potential future crises. We show quantitatively that these taxes respond to both the level and volatility of interest rates even though optimal decisions in the competitive equilibrium do not respond substantially to changes in volatility, and that the size of the optimal tax is non-monotonic with respect to external shocks.

JEL Classification: E3, E6, F3, F4, F6, G1, G2

Suggested Citation

Reyes-Heroles, Ricardo and Tenorio, Gabriel, Managing Capital Flows in the Presence of External Risks (September, 2017). International Finance Discussion Paper No. 1213, Available at SSRN: https://ssrn.com/abstract=3037928 or http://dx.doi.org/10.17016/IFDP.2017.1213

Ricardo Reyes-Heroles (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Gabriel Tenorio

Boston Consulting Group ( email )

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