Working Paper: CEPR ID: DP16717
Authors: Olivier Jeanne
Abstract: Many emerging market economies use foreign exchange interventions capital controls or at the same time as they float their currencies, a policy mix that is not explained by Mundell's policy trilemma. This paper presents a simple model that accounts for this fact. In the model, changes in foreign appetite for domestic assets lead to a trade-off between stabilizing the tradable sector and stabilizing the nontradable sector. The model is consistent with a number of stylized facts about the impact of the global financial cycle on emerging market economies, and on the policies used by emerging markets to mitigate this impact. Consistent with Rey's dilemma thesis, the benefits of using countercyclical capital flow taxes may be substantially larger than the benefits of floating. The paper also discusses the reasons that capitalflow taxes are not more popular in practice.
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Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Changes in foreign appetite for domestic assets (F31) | Tradeoff between stabilizing the tradable sector and the nontradable sector (F16) |
| Increase in UIP wedge (J65) | Depreciation of the peso (F31) |
| Depreciation of the peso (F31) | Negative impact on the tradable sector (F69) |
| Lowering interest rates (E43) | Stabilization of the nontradable sector (E69) |
| Allowing currency to appreciate (F31) | Harm to the tradable sector (F14) |
| Capital inflow pressures (F32) | Output gaps in both sectors (E20) |
| Optimal capital flow taxes (F38) | Mitigation of welfare losses associated with tradeoffs (D69) |