LAUSR

Abstract This paper explores the interactive role of optimal monetary policy and capital controls in dealing with ‘sudden-stop’ financial crises in emerging market economies. The model features collateral constraints embedding pecuniary externalities, as well as nominal rigidities in prices and wages. We explore the role of policy commitment and macro-prudential motives in the design of optimal monetary and capital market responses to crises, under alternative exchange rate regimes. We find that policy commitment is very important under flexible exchange rates, but commitment (to the path of capital taxes) is only of minor benefit under an exchange rate peg. As regards macro-prudential policy, we find the exact opposite. Under floating exchange rates, the optimal policy has almost no macro-prudential elements. On the other hand, when authorities are constrained by an exchange rate peg, macro-prudential policy is used aggressively as part of an optimal policy framework. An important additional finding is that the direction of capital controls is different under a fixed relative to a flexible exchange rate. With flexible exchange rates, policy makers impose inflow taxes immediately at the onset of a crisis. Under pegged exchange rates, they will impose capital inflow subsidies.