Abstract
Declines in interest rates in advanced economies during the global financial crisis resulted in surges in capital flows to emerging market economies and triggered advocacy of capital control policies. The paper evaluates the effectiveness for macroeconomic stabilization and the welfare implications of the use of capital account policies in a monetary DSGE model of a small open economy. The model features incomplete markets, imperfect asset substitutability, and nominal rigidities. In this environment, policymakers can respond to fluctuations in capital flows through capital account policies such as sterilized interventions and taxing capital inflows, in addition to conventional monetary policy. The welfare analysis suggests that optimal sterilization and capital controls are complementary policies.
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Notes
Central bankers in advanced economies defended these policies by maintaining that they were appropriate for stimulating their domestic economies, and that ensuring the recovery of the advanced economies was also in the interest of the emerging economies (for example, Bernanke, 2012).
The PBOC engages in extensive sterilization activity to maintain the country’s closed capital account in the face of persistent Chinese current account surpluses.
The Ramsey policy problem that we consider here is similar to the jointly optimal fiscal and monetary policy problem studied by Schmitt-Grohé and Uribe (2004).
Time-varying capital flow restrictions have been considered in a different context in previous studies (for example, Jeanne and Korinek, 2010 and Korinek, 2013).
A more comprehensive set of capital controls, with different tax schedules to accommodate differences in domestic and foreign asset demand, may mitigate the welfare gains from also engaging in sterilization. However, such a policy would likely be difficult to implement, as it would require different schedules for all of the adjustment margins considered.
Capital controls can also be a welfare-enhancing tool as a means of terms-of-trade manipulation. For a recent example, see Costinot, Lorenzoni, and Werning (2011).
Unsal (2013) considers a “monetary authority” that follows a standard interest rate rule in a real economy, while Korinek (2013) examines “reserve accumulation,” in the sense that a central planner purchases and holds foreign assets on behalf of domestic agents. Monacelli (2013) characterizes optimal monetary policy in an open economy as the constrained-efficient Ramsey allocation under preset prices, but does not consider capital account policies. Chang, Liu, and Spiegel (forthcoming) look at capital controls and sterilization policy in a DSGE model for the special closed capital account case of China. The capital account in Prasad (2013) is also closed.
Incorporating portfolio adjustment costs in our model helps pin down equilibrium dynamics of optimal portfolio holdings. More importantly, it implies imperfect substitutability between domestic and foreign assets, and therefore creating a scope for sterilization policy. Our approach is different from Devereux and Sutherland (2011), who propose an approach to obtaining equilibrium portfolio shares in a standard open-economy model without portfolio adjustment costs.
The results do not change if we normalize using aggregate output units.
The foreign investor’s demand schedule (equation (15)) can be derived from the foreign consumer’s optimizing decisions. In particular, the foreign bond Euler equations (analogous to equations (5) and (6)) imply that
where ψ*1 and ψ*2 are the adjustment-cost parameters for foreign consumers’ holdings of foreign bonds b* ft and domestic bonds b ft , respectively, and the other starred-variables correspond to the foreign counterparts to the domestic variables. Since the foreign variables are taken as given by the small open economy, we assume—without loss of generality—that all foreign variables (that is, the starred variables) are constant, except for R* t , which follows the stochastic process in Equation (7). Further, we normalize the steady-state foreign demand for domestic bonds
to zero. We then obtain Equation (15), with ψ4≡β*/ψ*2.The government’s flow of funds constraint reflects that any capital gains or losses on sterilization activity are internalized within the government. The revenues on capital inflow taxes (T t ) are separately transferred to the households in a lump-sum fashion.
See also Woodford (2003).
Evaluating welfare requires second-order approximations because the model’s risky steady state is in general different from the deterministic steady state (Kim and others, 2008; Coeurdacier, Rey, and Winant, 2011). Our approach to evaluating welfare based on second-order approximations is similar to the approach used by Schmitt-Grohé and Uribe (2004), which takes into account potential effects of the risky steady state.
The slope of the Phillips curve in our model is given by κ≡(θ−1)/(ψ3)(C)/(Y), where the steady-state ratio of consumption to gross output is
(so that the steady-state trade balance to output ratio is 2 percent, as in Mendoza (1991)). The values of θ=10 and ψ3=60 imply that κ=0.153. In an economy with Calvo (1983) price contracts, the slope of the Phillips curve is given by (1−βα
p
)(1−α
p
)/(α
p
), where α
p
is the probability that a firm cannot reoptimize prices. A slope of 0.153 for the Phillips curve in the Calvo model implies that α
p
=0.68 (taking β=0.99 as given), which corresponds to an average price contract duration of about three quarters. The study by Nakamura and Steinsson (2008) shows that the median price contract duration is between 8 and 12 months.The qualitative results do not change for a reasonable range of these shock parameters.
To keep our analysis tractable, our model has neither capital nor nontradable goods. In a more general model with investment, foreign interest rate declines may trigger capital inflow surges and could lead to investment booms, potentially raising output and inflation. Nonetheless, we would expect the sterilization and capital control policies that we consider here to be similarly useful for stabilization in these environments.
This can be seen from a first-order approximation of the Euler equation (6) for the household’s foreign bond holdings.
Our simulation results suggest that this welfare loss mainly stems from a modest reduction in the stochastic mean of consumption under the constrained regime. Because of imperfect risk-sharing, our steady-state outcome is also distorted. This leaves first-order terms such as the stochastic mean of consumption relevant for welfare. This drives the distinction in welfare outcomes between the first and second regimes despite the apparently similar second-order macroeconomic stability outcomes.
Since our model is stylized and we focus on specific shocks and specific types of asset market frictions, the magnitude of relative welfare losses can be sensitive to the inclusion of other shocks and frictions in the model. We leave for future research to investigate the welfare implications of capital account policies in a model with more realistic frictions and a broader set of shocks.
to zero. We then obtain 
(so that the steady-state trade balance to output ratio is 2 percent, as in References
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Additional information
*Zheng Liu is Senior Research Advisor at the Federal Reserve Bank of San Francisco and Mark M. Spiegel is Vice President at the Federal Reserve Bank of San Francisco. The authors thank Olivier Blanchard, Dean Corbae, Charles Engel, Pierre-Olivier Gourinchas, Young Sik Kim, Ken West, seminar participants at the Federal Reserve Bank of San Francisco, the IMF-BOK conference on “Asia: Challenges of Stability and Growth,” the Banque de France, the 7th Annual MIFN Conference, UC Santa Cruz, the University of Wisconsin Madison, the National University of Singapore, and two anonymous referees for helpful comments.
Appendix I
Appendix I
Derivations of the Ramsey Optimal Policy Problem
In this appendix, we derive the Ramsey planner’s optimizing decisions. The planner maximizes the welfare objective
taking as given the private sector’s optimizing decisions summarized below.
To keep the Ramsey problem tractable, we further reduce the set of private optimizing conditions by substituting out the six variables w t , b ht , b* ht , l t , ca t , and tb t using Equations (A.3) and (A.9)–(A.13). The private optimizing conditions can then be reduced to seven equations.
The Lagrangian for the Ramsey planner’s optimal policy problem is given by
The planner solves the optimal policy problem by choosing the 10 endogenous variables summarized in the vector
along with the seven Lagrangian multipliers λjt for j∈{1, 2, …, 7}. The first-order conditions are summarized below.
The Ramsey optimal policy solution corresponds to the solution to the 17 Equations (A.2), (A.4)–(A.8), (A.14), and (A.16)–(A.25) for the 17 variables including the 10 variables in the vector X t and the seven Lagrangian multipliers for the Ramsey problem.
We solve the Ramsey problem with calibrated parameters. To evaluate welfare under the Ramsey optimal policy, we solve the Ramsey problem by taking second-order approximations of all optimizing decisions around the Ramsey steady state. This approach takes into account the effects of shocks on the stochastic means of the endogenous variables, which are important for welfare calculations (Schmitt-Grohé and Uribe, 2004; Kim and others, 2008).
