International Reserve Management Under Rollover Crises

The paper extends the Cole-Kehoe (2000) sovereign rollover crisis model to include international reserves and derives the joint optimal management of sovereign debt and reserves in a small open economy subject to potential creditor coordination failure. The central results are: (i) reserves are only valuable as a rollover-crisis defense when debt has sufficiently long maturity; (ii) the optimal exit path from the crisis zone requires holding zero reserves while gradually reducing debt, then jumping simultaneously to the optimal safe pair (a*, b*) by issuing new debt while accumulating reserves; (iii) this seemingly paradoxical debt-financed reserve accumulation lowers bond spreads because it moves the economy fully into the safe zone.

Liquidity Traps, Prudential Policies, and International Spillovers

The paper develops a tractable open-economy New Keynesian model with nominal rigidities and an occasionally binding zero lower bound (ZLB) to study how monetary policy and macroprudential policy (modeled as a tax on capital flows) jointly transmit to output, capital flows, and the exchange rate, and what this implies for international spillovers and global welfare. An analytical decomposition identifies three transmission channels — intertemporal substitution, expenditure switching, and aggregate income — and the calibration finds that capital controls operate almost entirely through intertemporal substitution (about 95%), whereas expenditure switching accounts for roughly a quarter to a third of the effect of monetary policy. On the normative side, the authors show that, absent capital controls, monetary policy faces a tradeoff between stabilizing output today and curbing capital flows to lower the likelihood of a future liquidity trap, but that ’leaning against the wind’ (pre-emptively raising rates) is not necessarily optimal and can be counterproductive when tradables and non-tradables are highly substitutable. Quantitatively, adding capital controls lowers the average unemployment rate conditional on a liquidity trap from about 6% to about 1.5% and cuts the unconditional welfare cost of liquidity traps from about 0.4% to about 0.1% of permanent consumption, with an average ex-ante tax on inflows of about 0.2% and an average ex-post tax on outflows of about -0.05%. Finally, contrary to ‘currency war’ concerns, the authors argue that capital controls are not beggar-thy-neighbor: a country can use them to insulate itself from adverse foreign-policy spillovers (which operate through the world real interest rate), and coordination is beneficial only during a liquidity trap and works by stimulating rather than restricting flows. All results hold within their small-open-economy model under its calibration.

Javier Bianchi | Macro Paper Warehouse

International Reserve Management Under Rollover Crises

Liquidity Traps, Prudential Policies, and International Spillovers