Liquidity Traps, Prudential Policies, and International Spillovers
What this paper finds — and why it matters
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.
Summary of a forthcoming paper, AI-assisted and human-reviewed. See the linked original for the authoritative claims and full conditions.
Q1. What is the model, and which policies does it study?
The paper studies an infinite-horizon small open economy with nominal rigidities and an occasionally binding zero lower bound on the nominal interest rate, in which the government has two instruments — the nominal interest rate (monetary policy) and a tax on capital flows (macroprudential policy). The economy has a tradable final good and a non-tradable good with sticky prices, and features aggregate demand externalities. The authors use this setting to ask three questions: how interrelated are the transmission channels of the two policies; how should monetary policy be used jointly with macroprudential policy; and what happens to global welfare when many countries adopt prudential policies simultaneously.
Q2. What are the three transmission channels, and how much does each matter?
An analytical decomposition (extending Kaplan, Moll and Violante 2018 and Auclert 2019 to an open economy) identifies three channels — intertemporal substitution, expenditure switching, and aggregate income — and the calibration shows monetary policy and capital controls operate through very different channels. The intertemporal substitution channel accounts for about 95% of the effect of capital controls, while expenditure switching (operating through exchange-rate depreciation that shifts demand toward non-tradables) accounts for a substantial share of the effect of monetary policy — the paper states ‘about one-third’ in its introduction and ‘about one-quarter’ in its conclusion. The expenditure-switching channel and the role of the exchange rate are what distinguish the open-economy decomposition from its closed-economy antecedents.
Q3. Do open capital markets amplify or dampen monetary policy?
Capital flows may either amplify or attenuate the output effects of monetary policy, depending on the relative sizes of the elasticity of substitution over time and the elasticity across sectors. If the intertemporal elasticity exceeds the intratemporal one, an open capital account amplifies monetary policy (a monetary expansion raises total consumption more than output, so households borrow from abroad); the result reverses when the intratemporal elasticity is larger, in which case a closed capital account produces the larger output expansion.
Q4. Is ’leaning against the wind’ the optimal prudential use of monetary policy?
Contrary to a widespread policy view, leaning against the wind is not necessarily optimal: when the elasticity of substitution across sectors is higher than across time, raising the interest rate ahead of a liquidity trap can be counterproductive. In that case a rate hike generates a large negative expenditure-switching effect and a sharp income drop while only modestly reducing consumption, so in general equilibrium it leads to capital inflows and more external debt — exacerbating the aggregate demand externality and making a future contraction more likely. The implication is that a prudential monetary policy may require lowering, not raising, the interest rate ahead of a liquidity trap.
Q5. How should monetary and macroprudential policy be combined, and how pre-emptively?
When capital controls are available, the central bank uses monetary policy to stabilize output and uses the capital-flow tax to manage flows, with the macroprudential tax on debt positive only if the ZLB is likely to bind next period; monetary policy, by contrast, must be used prudentially even when the ZLB binds only in some distant future. Because monetary policy is a blunter instrument, it has to be used more pre-emptively than capital controls. The authors also show the central bank may restrict outflows during a liquidity trap when that trap is either temporary or very severe.
Q6. What are the quantitative welfare and unemployment gains from capital controls?
Adding capital controls substantially improves macroeconomic stabilization: average unemployment conditional on a liquidity trap falls from about 6% to about 1.5%, and the unconditional welfare cost of liquidity traps falls from about 0.4% to about 0.1% of permanent consumption — more than a fourfold reduction. The average ex-ante prudential tax on inflows is about 0.2% and the average ex-post tax on outflows is about -0.05%. The authors also note that, with capital controls, liquidity traps are less frequent and less severe but — perhaps surprisingly — tend to last longer.
Q7. Are capital controls beggar-thy-neighbor, and how do international spillovers work?
The authors argue that, contrary to emerging policy concerns, capital controls are not beggar-thy-neighbor and can enhance global macroeconomic stability; international spillovers operate through the world real interest rate, and a country can use capital controls to insulate itself from adverse foreign policies. In their multi-country extension, a country can remain insulated from negative spillovers of a change in the foreign monetary stance through capital controls, which can help prevent the outbreak of a currency war.
Q8. When is international policy coordination desirable?
The authors provide conditions under which a regime of uncoordinated capital controls can dominate laissez-faire, and they find that coordination is desirable only during a liquidity trap — where, notably, it calls for stimulating capital flows rather than preventing them. This stands against the view that uncoordinated capital-control policies necessarily produce a global paradox of thrift.
Q9. How do these results differ from prior open-economy liquidity-trap models?
The paper’s more benign view of spillovers contrasts with contributions such as Caballero, Farhi and Gourinchas (2021), Eggertsson et al. (2016), and Fornaro and Romei (2019), and the authors trace the difference to two features of their model: positive liquidity and the presence of ex-post capital controls. Because goods subject to nominal rigidities are consumed only domestically, foreign policies that favor savings (lowering the world interest rate) raise demand for domestic goods through asset markets and can be stabilizing at the ZLB; and ex-post controls let the central bank actively manage flows during a trap to offset adverse spillovers.
Key concepts
aggregate demand externality : the externality (as in Schmitt-Grohe and Uribe 2016 and Farhi and Werning 2016) by which an individual agent’s borrowing raises external debt and, given nominal rigidities and the ZLB, makes the economy more vulnerable to a future demand-driven contraction; it is the market failure that prudential policy targets in this model.
expenditure switching channel : the open-economy transmission channel through which an exchange-rate depreciation makes non-tradables relatively cheaper, shifting demand toward domestically produced goods; the paper finds it accounts for a substantial share (roughly a quarter to a third) of monetary policy’s effect.
intertemporal substitution channel : the channel through which a change in the intertemporal price shifts consumption between present and future; it accounts for about 95% of the effect of capital controls in the calibration.
liquidity trap / occasionally binding ZLB : a state in which the zero lower bound on the nominal interest rate binds, so conventional monetary policy cannot stabilize output; the risk of entering such a state in the future is what makes pre-emptive prudential policy valuable here.
capital controls (prudential tax on flows) : the macroprudential instrument in the model — a tax on capital inflows (ex ante) or outflows (ex post) — used to manage the level and timing of capital flows and to insulate the economy from foreign spillovers.
beggar-thy-neighbor : a policy that improves one country’s outcomes at others’ expense; the paper argues capital controls are, contrary to common concern, not beggar-thy-neighbor in its setting and can raise global stability.