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Managing Capital Flows in the Presence of External Risks

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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.

Suggested Citation

  • Ricardo M. Reyes-Heroles & Gabriel Tenorio, 2017. "Managing Capital Flows in the Presence of External Risks," International Finance Discussion Papers 1213, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgif:1213
    DOI: 10.17016/IFDP.2017.1213
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    Cited by:

    1. Ricardo M. Reyes-Heroles & Gabriel Tenorio, 2017. "Interest Rate Volatility and Sudden Stops : An Empirical Investigation," International Finance Discussion Papers 1209, Board of Governors of the Federal Reserve System (U.S.).
    2. Reyes-Heroles, Ricardo & Tenorio, Gabriel, 2019. "Regime-switching in emerging market business cycles: Interest rate volatility and sudden stops," Journal of International Money and Finance, Elsevier, vol. 93(C), pages 81-100.
    3. Jensen, Henrik & Ravn, Søren Hove & Santoro, Emiliano, 2019. "Kinks and Gains from Credit Cycles," CEPR Discussion Papers 13795, C.E.P.R. Discussion Papers.

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    More about this item

    Keywords

    Macroprudential policy; time-varying volatility; sudden stops; financial crises; external interest rates;
    All these keywords.

    JEL classification:

    • E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
    • F3 - International Economics - - International Finance
    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance
    • F6 - International Economics - - Economic Impacts of Globalization
    • G1 - Financial Economics - - General Financial Markets
    • G2 - Financial Economics - - Financial Institutions and Services

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