Mundell meets Poole: Managing capital flows with multiple instruments in emerging economies

Abstract

We study the optimal management of capital flows in a small open economy model with financial frictions and multiple policy instruments. The paper reports two main findings.. First, both foreign exchange intervention (FXI) and macroprudential policies are tools complementary to the monetary policy rate that can greatly reduce inflation and output volatility in a scenario of capital outflows. Second, the optimal policy mix depends on the underlying shock driving capital flows. FXItakes the leading role in response to foreign interest rate shocks, while macroprudential policy becomes the prominent tool for domestic risk shocks. These results blend the policy prescriptions of Mundell (1968), who stated that “policies should be paired with the objectives on which they have the most influence” and Poole (1970), who showed that the optimal policy instrument ultimately depends on the underlying shock hitting the economy.