A Conceptual Model for the Integrated Policy Framework

It is reacting against the Mundell-Fleming result that flexible exchange rates plus a standard policy rate deliver full employment and low inflation after any shock, on the grounds that the assumptions behind both its trade and its finance blocks are contradicted by the evidence (Introduction, pp. 3-4). The authors’ framing is that Mundell-Fleming “remains the workhorse framework for the analysis of small open economies in the policy space,” delivering its result “partly because of a powerful expenditure-switching channel that operates both on the import side and on the export side” – and then that “the world is more complex than modeled in the Mundell-Fleming framework: the rigidity of prices can take different forms, and international and domestic financial imperfections are prevalent” (p. 3). Two observations motivate the exercise. On the evidence side: dollar invoicing shares above 80 percent in many emerging markets, prevalent foreign-currency borrowing, intermediaries with “limited appetite for taking on emerging markets’ currency exposure” so that UIP breaks down, and the pattern that heavy FX intervenors during depreciations “tend to be the countries where balance sheet concerns prevail, and where financial markets are not deep enough to provide hedging opportunities” (p. 3). On the behaviour side: during COVID-19, “most countries lowered policy rates and eased macroprudential regulation, some complemented it with sales of foreign exchange reserves to lean against the depreciation. At the same time, a few countries relaxed their restrictions on capital inflows” (p. 4). The paper’s stated aim is diagnostic rather than normative-in-general: “to establish under what conditions the standard prescription of flexible exchange rates still holds, and when it may instead be optimal to rely on other tools” (p. 4).

A three-period small open economy with three sectors, two occasionally-binding borrowing constraints, segmented international asset markets, and a constrained planner who moves either before or after a period-1 shock (Section 3, pp. 17-19). The three sectors are the tradable differentiated-goods sector (firms with pricing power and sticky prices, either PCP or DCP), a commodity sector in which the country is a price taker and receives an endowment it exports, and a nontradable housing sector where firms use land to produce housing services at flexibly-set rental prices. Housing firms are split between a linear-technology subset and a concave-technology subset; only the linear subset faces the collateral constraint. On the financial side, domestic banks borrow from international financial intermediaries and lend on to households and housing firms; the banks’ external borrowing is capped at a fraction of the domestic price of the tradable good, and the linear housing firms must post a fraction of land value as collateral. Both constraints “are not binding in normal times, but they become binding after sufficiently large adverse shocks” (p. 5). There are two noncontingent assets, a domestic-currency bond and a dollar bond, with segmentation: “domestic agents can only trade the domestic currency bond, while international financial intermediaries can trade in both bonds” (p. 17). Households have Cole-Obstfeld log preferences over the three consumption goods with the Gali-Monacelli linear disutility of labor. Uncertainty resolves entirely after the period-1 shock. Fiscal policy is deliberately excluded: “we assume that fiscal policy is generally not flexible enough to respond to shocks within the horizon considered” (fn. 1).

From domestic households’ ownership share of the international financial intermediaries, not from a directly assumed foreign-currency liability. The intermediaries “borrow in foreign currency on the world market and satisfy the domestic banks’ domestic currency borrowing needs,” and are “partly foreign and partly owned by domestic agents: this domestic ownership is the source of the economy’s currency mismatch” (p. 5). The two limiting cases are explicit: full domestic ownership “corresponds to the highest degree of currency mismatch,” while no domestic ownership “is the same as the country borrowing only in its own currency” (pp. 5-6). This modelling choice matters for the policy conclusion in Q9, because it means the mismatch can in principle be removed by restricting the FX positions of the domestically-owned intermediaries.

Four are taken seriously; the terms-of-trade externality is the one the authors deliberately set aside (pp. 6-7). The list: (i) the Keynesian aggregate demand externality, from sticky tradable prices – “typically the key friction in models of monetary policy”; (ii) a terms-of-trade externality from firms’ pricing power and downward-sloping export demand, under which “firms tend to produce too much and set prices too low”; (iii) a pecuniary aggregate demand externality from the banks’ constraint interacting with FX exposure, which “leads to overborrowing and overly appreciated exchange rates ex ante, and to too little borrowing and overly depreciated exchange rates ex post after adverse shocks that make the constraint bind”; (iv) a pecuniary production externality in housing, where firms “do not internalize the effects of their borrowing and production decisions on land prices,” so that after adverse shocks depressed land prices further tighten their own constraint; and (v) a financial terms-of-trade externality, present only under shallow FX markets, where agents “do not take into account that their borrowing decisions impact the external premium that the economy as a whole needs to pay.” On (ii) the authors are openly hedged: “Even though this externality arises naturally in our setting, it is not clear that it is relevant for policymaking in the real world, so we focus on results that do not hinge on it, and in some cases we set parameterizations that neutralize it” (p. 7).

No. Absent other frictions, flexible exchange rates remain optimal under DCP – but they have to move more to achieve the same stabilisation. Under DCP “exchange rate adjustment becomes a weaker tool: while it continues to affect import consumption, it no longer affects the competitiveness of exports on world markets, as dollar prices remain unchanged” (pp. 7-8). The authors nonetheless report that “while pricing in the dominant currency reduces the benefits of exchange rate flexibility and generally features under- or over-exporting, we find flexible exchange rates to be optimal in absence of other frictions” (p. 9). And with deep FX markets and no borrowing constraints, “policies such as capital controls do not improve efficiency beyond the terms of trade externality. The reason is that capital controls do not address the stickiness of export prices in the dominant currency” (p. 9). The compensating cost is volatility: “under most shocks, the DCP economy is characterized by more volatile exchange rates than the PCP economy… Therefore, in the absence of financial frictions, the DCP economy stabilizes aggregate demand through larger exchange rate movements” (pp. 9-10).

A binding-in-the-future bank borrowing constraint does, through the pecuniary aggregate demand externality; and both the incidence and the intensity of controls depend on whether the economy is PCP or DCP (pp. 10, 8-9). The chain the authors describe: adverse shocks to commodity prices or to banks’ debt limits can make the external constraint bind ex post and lead to overborrowing ex ante, and once the constraint is in play “depreciating the exchange rate after an adverse shock becomes costlier as a depreciation would further tighten the constraint. Thus, monetary policy weighs the macro benefits of depreciation against the financial costs” (p. 10). The consequence is an ex-post exchange rate more appreciated than pure stabilisation would call for, so “aggregate demand is depressed ex post relative to the level that stabilizes price pressures,” and “prudential capital controls are needed to shift demand intertemporally from normal times to the period of distress, by curbing demand before the shock and stimulating it afterwards” (p. 10). Two comparative results are stated precisely: “for economies vulnerable to commodity price shocks, a wider set of unhedged external debt levels can justify prudential capital controls under DCP than PCP; and for economies vulnerable to commodity price or debt limit shocks, prudential capital controls are larger under DCP than PCP” (p. 10). The authors also record a cost – “capital controls can distort capital flows relative to the efficient benchmark, which may generate welfare losses since those flows can be beneficial for the recipient countries” – and a timing rule: “prudential capital controls need to be raised counter-cyclically during booms in external debt and reduced during busts” (p. 8).

Only under a specific condition – that macroprudential taxes cover the entire economy. Otherwise they are imperfect substitutes or outright complements (pp. 10-11). The isomorphism result: “Domestic macroprudential taxes on consumer debt are perfect substitutes for capital controls when macroprudential taxes cover the entire economy,” because with all external flows channelled through domestic banks, “taxing domestic banks’ borrowing at the border is isomorphic to taxing the domestic debt of every domestic agent” (p. 10) – a result the authors caveat as resting on their modelling of banks, noting it “may not be the case with a richer modeling of domestic banks” (fn. 4). Two failures follow. If some agents can borrow directly from abroad and sit outside the macroprudential perimeter, “macroprudential taxes become an imperfect substitute for capital controls.” If they are inside the perimeter but can evade, “capital controls and macroprudential taxes need to be deployed together and move in tandem, because otherwise, these agents would borrow either entirely domestically or entirely externally depending on which taxes are smaller” (p. 11). A third failure appears later: with shallow FX markets and housing frictions, using consumer macroprudential taxes in place of capital controls requires a policy-rate increase to deliver the higher external premium, and that increase can push land prices down and make the housing constraint bind – “leading to a fundamental difference between capital controls and macroprudential consumer debt taxes” (fn. 6).

It bypasses the intermediary inefficiency by changing the quantity of external debt intermediaries must absorb, and hence the premium – at the cost of a carry loss on reserves. “Sterilized FX intervention circumvents the inefficiency of financial intermediaries in countries with shallow FX markets. It achieves this objective by changing the quantity of external debt that needs to be absorbed by the financial intermediaries and therefore the associated premium” (p. 9). After an adverse foreign-appetite shock, “FX sales reduce the need for the policy rate to be increased, and in that sense can enhance monetary autonomy,” and by relieving the pressure on the policy rate they also prevent a fall in land prices “and thereby avoid[] the shock spilling over to the housing sector” (p. 9). The cost is stated in the same paragraph: “reserve accumulation involves buying low-return foreign currency bonds and selling high-return domestic currency bonds, which incurs a carry cost” (p. 9). The authors also distinguish the channel from that of capital controls even where the macro effects look similar: “FX sales reduce the total effective outflow that the financial intermediaries need to absorb, decreasing the necessary external premia. Capital controls detach the external premia from the policy rate, so that a loosening of controls can provide higher returns to foreigners without a change in the policy rate” (fn. 5).

Under deep FX markets, yes – a ban addresses the pecuniary aggregate demand externality and removes the need for prudential capital controls. Under shallow FX markets it can backfire. Since the mismatch comes from ownership of the intermediaries, “it seems sensible to ban open FX positions for those intermediaries which are domestically owned and let domestic currency debt be absorbed entirely by foreign-owned intermediaries,” and “such bans on FX exposures are optimal under deep markets because they address the pecuniary aggregate demand externality and eliminate the need for prudential capital controls” (p. 11). But “under shallow FX markets, the ban leads to fewer investors willing to finance external debt and makes FX markets even shallower. As a result, it increases the vulnerability to foreign appetite shocks, i.e., shocks to the foreigners’ willingness to hold domestic currency debt. In turn, it may make the economy more dependent on FX intervention, by increasing the marginal value of FX intervention” (p. 11).

It adds a channel by which depreciation relaxes a domestic-currency collateral constraint, which is new relative to the closed-economy housing literature. The standard mechanism is present – economies with high housing debt “should impose macroprudential housing debt taxes in normal times, and relax them (together with monetary policy) to support land prices when the housing constraints bind” (pp. 12-13). The new open-economy channel: “an exchange rate depreciation generates expenditure switching not only towards the domestically produced traded good but also towards housing services. This increased demand for housing services bolsters rents and land prices, and relaxes housing borrowing constraints that are set in domestic currency” (p. 13). Stripping out all policy instruments and comparing a floating with a fixed rate after a housing debt-limit shock shows “the exchange rate depreciates and relaxes the housing sector constraint, even possibly to the extent of making macroprudential housing debt taxes unnecessary” (p. 13). The authors immediately note the tension: the depreciation that best relaxes the housing constraint need not match the policy-rate cut that is desirable on other grounds, and if the cut over-depreciates, “capital inflow subsidies (or reductions in inflow taxes) or FX sales can contain the depreciation associated with the policy rate cut and avoid excessive expenditure switching” (p. 13). DCP turns out to help here, in contrast to its effect on FX-denominated constraints: because DCP’s larger exchange rate swings come with weaker expenditure switching, “the DCP economy faces an easier trade-off between relaxing the housing constraint and demand stabilization,” which “translates into smaller ex ante macroprudential housing taxes under DCP” (p. 13).

Yes, in both directions, and that is one of the paper’s reasons for rejecting a clean assignment of tools to shocks. Housing-to-external: after an adverse housing debt-limit shock the exchange rate depreciates to relax the domestic-currency constraint, but if the banks’ constraint is also live, “the depreciation lowers their debt limit in FX terms and tightens their constraint,” so interest rates and capital controls should be used ex ante “to reduce the interest burden on inherited housing sector debt and to limit external FX debt,” and ex post “it becomes optimal for the exchange rate not to depreciate by as much as it would in the absence of the banks’ borrowing constraint” (pp. 13-14). External-to-housing: a bank debt-limit shock brings a large policy-rate cut and depreciation that raise the domestic-currency value of rents and land, but also a higher borrowing rate for households and housing firms and lower household consumption, which push the other way – “if the latter effects are larger than the former ones, the housing constraint may bind,” making ex-ante housing macroprudential taxes optimal (p. 14). Here again DCP insulates: “since the exchange rate depreciation is larger and the increase in the domestic borrowing rate is smaller under DCP after external debt limit shocks, the housing market is better insulated under DCP” (p. 14).

It depends on whether the sudden stop hits all banks or only some. “The more standard use of FX intervention to affect the exchange rate by distorting premia in shallow FX markets does not help when the borrowing constraint binds for all banks. In fact, we find that in those cases, the only role for ex post FX intervention is to absorb external premia. The reason is that once the external constraint binds, the policy rate becomes available to manage the exchange rate costlessly, as it can no longer affect the domestic agents’ decisions” (p. 14). If only some banks are cut off, there is a case: the policy rate should be cut to relax the domestic housing constraint, but that causes a depreciation which tightens the external constraint, and “FX sales can then help limit the depreciation, improving the trade-off between relaxing the housing constraint and the external constraint” (pp. 14-15).

Three, all about instrument interaction rather than about any single tool’s effectiveness (pp. 15, 93). First, “policy instruments are not created equal: they operate through different margins. If an additional tool becomes available, it does not mean one should use it because it just may not be the right tool,” the example being that capital controls are useless against under- or over-exporting and employment destabilisation under DCP. Second, “instruments generally affect multiple imperfections, so the use of an existing policy may be reduced or increased after a new tool becomes available, that is, tools may be substitutes or complements,” exemplified by “the ambiguous effects of prudential capital controls on the use of monetary policy under deep FX markets.” Third, “there is no strict assignment of domestic policies (policy rate and macroprudential debt taxes) to domestic shocks and domestic frictions or external policies (capital controls and FX intervention) to external shocks and external frictions” – the housing-firm domestic-currency constraint being the case where optimal policy reaches for capital controls and FX intervention “regardless of whether the underlying source of shocks is domestic or external.”

It rules out fiscal policy, treats country characteristics as exogenous, assumes full policy credibility and commitment, and analyses only one country’s problem. The authors list four limits of the framework and three implementation challenges (Section 7, pp. 93-94). Country characteristics “can be endogenous to policy actions, particularly in the long term”: the private sector may take on more mismatch where reserves are high if it expects those reserves to over-stabilise the exchange rate, and “the development of FX markets is hindered through the use of capital controls or FX intervention” is raised as a possibility. Credibility is absent from the model but matters for the conclusion: “considerations of imperfect policy credibility may call for using fewer rather than more instruments until the country builds credibility, and the policy trade-offs may be different during this transition.” The analysis is unilateral – “spillovers and spillbacks should be considered when assessing the cost and benefits of policies from a global perspective.” And on implementation the authors note that the tools “may be assigned to different agencies in some countries, and coordination between them may be imperfect,” that “the identification of shocks in real time may be difficult,” and that with multiple instruments the communication problem – explaining “how policy tools will be used in different states of nature in the future, and how to verify that the central bank is honoring its previous promises” – “becomes more complex, and transitional arrangements may be necessary.”