A Conceptual Model for the Integrated Policy Framework

The Mundell-Fleming benchmark says a flexible exchange rate plus a standard interest-rate rule fully insulates a small open economy, and this paper asks what that prescription survives once the world’s actual imperfections are added. It builds a three-period small open economy – households, a government, tradable-goods firms, housing-sector firms, domestic banks, and international financial intermediaries partly owned by domestic households – and gives a constrained social planner with full commitment four instruments: the policy rate, taxes or subsidies on capital inflows, sterilized FX intervention, and macroprudential taxes on domestic bank lending to households and to housing firms. Each can be used ex ante, in period 0 before a shock, or ex post, in period 1 after one. Countries differ along seven characteristics – currency of trade invoicing, commodity export share, stock of debt, currency mismatch, external debt limit, depth of FX markets, and housing-sector debt limit – and are hit by six shocks: productivity, commodity prices, the world interest rate, the external debt limit, foreign risk appetite, and the housing debt limit. The frictions are deliberately layered. Export prices are sticky either in the producer’s currency (PCP) or in a dominant currency (DCP), motivated by the observation that “many emerging markets have dollar invoicing shares above 80 percent.” An occasionally-binding constraint caps domestic banks’ external debt at a fraction of the domestic tradable price, in the spirit of Mendoza (2010), Bianchi (2011) and Farhi and Werning (2016); another caps housing firms’ debt at a fraction of their land value, following Kiyotaki and Moore (1997); and asset-market segmentation following Gabaix and Maggiori (2015) means intermediaries have limited capacity to bear the country’s currency exposure, so uncovered interest parity fails – the paper’s “shallow FX markets.” Five externalities follow: the standard Keynesian aggregate demand externality, a terms-of-trade externality the authors deliberately downplay and sometimes parameterise away, a pecuniary aggregate demand externality from the banks’ constraint interacting with currency mismatch, a pecuniary production externality in housing, and a financial terms-of-trade externality that exists only when FX markets are shallow. The results are a mapping from shock-and-characteristic combinations to instrument settings rather than a set of point estimates: this is a conceptual model illustrated by simulations, and it reports directions, signs and comparisons across regimes rather than calibrated magnitudes. Flexible exchange rates remain optimal for a class of cases, including under DCP when there are no financial frictions – though the DCP economy then needs larger exchange rate movements to do the same stabilising work. Financial frictions are what break the benchmark: when future shocks can make the banks’ constraint bind, prudential capital controls are warranted in normal times; capital controls and macroprudential consumer taxes are perfect substitutes only when the macroprudential perimeter covers the whole economy; FX sales and looser inflow taxes both buy monetary autonomy after a foreign-appetite shock, and buy more of it used together; and housing and external constraints can each trigger the other, so ex-ante housing macroprudential taxes may be needed in anticipation of external as well as domestic shocks. Three broad principles close the analysis: instruments are not interchangeable and a newly available tool may simply be the wrong one; instruments affect multiple imperfections, so adding one can raise or lower the use of another; and there is no strict assignment of domestic tools to domestic shocks or external tools to external shocks.

Misallocation and Capital Market Integration: Evidence From India

Misallocation is a leading explanation for income differences across countries, but the literature has two problems: measures built on cross-sectional dispersion in marginal revenue products are inflated by measurement error and model misspecification, and dispersion measures are largely silent about which policies would reduce misallocation. India’s staggered liberalisation of foreign equity investment addresses both. Over the 2000s the Indian government granted automatic approval of foreign direct investment up to at least 51 percent of domestic firms’ equity, industry by industry, in two waves (2001 and 2006), coded at the 5-digit NIC level. Combining that policy variation with a 1995-2015 panel of 5,013 large and medium-sized manufacturing firms across 337 industries from the Prowess database, the paper runs a difference-in-differences with heterogeneous effects: does the reform raise capital differentially for firms that had high marginal revenue products of capital before it? The identifying requirement is weaker than what cross-sectional work needs – not random assignment, nor balanced pre-reform levels, only that the high-versus-low-MRPK gap would have evolved similarly in treated and untreated industries. For the average firm, capital rose 32 percent and MRPK fell 18.7 percent, with revenues and wage bills positive but not significant. The heterogeneity is the result: relative to low-MRPK firms, high-MRPK firms raised physical capital by 53 percent, revenues by 23 percent and wage bills by 28 percent, and cut MRPK by 33 percent, while low-MRPK firms were essentially unaffected – so dispersion in MRPK narrowed without shrinking anyone, and at least some of India’s observed MRPK dispersion is real misallocation rather than noise. Effects build slowly: they take three to four years to reach those magnitudes and reach +79 percent capital and -46 percent MRPK by ten years. The same pattern holds for labour, with high-MRPL firms raising wage bills 24 percent and cutting MRPL 28 percent, closing about a fifth of the MRPL gap. Effects are largest where the pre-reform state banking sector was least developed, which the paper reads as evidence that domestic banking inefficiency is part of the source. Product-level data show prices falling 17 percent on average and 21 percent for high-MRPK firms, with output up and product portfolios expanding for those firms. Aggregating with a first-order Solow-residual decomposition that avoids the usual lognormality and returns-to-scale assumptions, the treated industries’ Solow residual rises by at least 3.4 percent, 6.2 percent once the policy’s growing effects over five years are cumulated, and 16.3 percent under the conventional cross-sectional way of inferring baseline wedges – the range the paper reports as 3 to 16 percent, with the low end its deliberate lower bound.

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A Conceptual Model for the Integrated Policy Framework

Misallocation and Capital Market Integration: Evidence From India