A Conceptual Model For The Integrated Policy Framework

In the Mundell-Fleming framework, standard monetary policy and exchange rate flexibility fully insulate economies from shocks. However, that framework abstracts from many real world imperfections, and countries often resort to unconventional policies to cope with shocks, such as COVID-19. This paper develops a model of optimal monetary policy, capital controls, foreign exchange intervention, and macroprudential policy. It incorporates many shocks and allows countries to differ across the currency of trade invoicing, degree of currency mismatches, tightness of external and domestic borrowing constraints, and depth of foreign exchange markets. The analysis maps these shocks and country characteristics to optimal policies, and yields several principles. If an additional instrument becomes available, it should not necessarily be deployed because it may not be the right tool to address the imperfection at hand. The use of a new instrument can lead to more or less use of others as instruments interact in non-trivial ways.

This paper jointly analyzes the optimal conduct of monetary policy, foreign exchange intervention, fiscal policy, macroprudential policy, and capital flow management. This policy analysis is based on an estimated medium-scale dynamic stochastic general equilibrium (DSGE) model of the world economy, featuring a range of nominal and real rigidities, extensive macrofinancial linkages with endogenous risk, and diverse spillover transmission channels. In the pursuit of inflation and output stabilization objectives, it is optimal to adjust all policies in response to domestic and global financial cycle upturns and downturns when feasible—including foreign exchange intervention and capital flow management under some conditions—to widely varying degrees depending on the structural characteristics of the economy. The framework is applied empirically to four small open advanced and emerging market economies.

We estimate a New Keynesian small open economy model which allows for foreign exchange (FX) market frictions and a potential role for FX interventions for a large set of emerging market economies (EMEs) and some inflation targeting (IT) advanced economy (AE) countries serving as a control group. Next, we use the estimated model to examine the empirical support for the view that interest rate policy may not be sufficient to stabilize output and inflation following capital outflow shocks, and the extent to which FX interventions (FXI) can improve policy tradeoffs. Our results reveal significant structural differences between AEs and EMEs—in particular FX market depth—leading to different transmission of capital outflow shocks which justifies occasional use of FXI in some EMEs in certain situations. Our analysis also highlights the critical importance of accounting for the endogeneity of FXI behavior when assessing FX market depth and policy tradeoffs associated with volatile capital flows in past episodes.

Against the background of a strong economic performance over the last quarter of a century, Peru has been hit by multiple shocks in the last several years. Adequate policies and very strong policy frameworks have made the economy resilient. Following a steep decline in 2020 at the outset of the pandemic and a rapid recovery in 2021, growth slowed significantly in 2022 as the policy stimulus was withdrawn and external and financial conditions deteriorated. Recent political developments suggest that the new government needs to work across the political spectrum to create broader political consensus, reduce uncertainty, ease social tensions, and boost growth.

The Mundell-Fleming IS-LM approach has guided generations of economists over the past 60 years. But countries have experienced new problems, the international finance literature has advanced, and the composition of the global economy has changed, so the scene is set for an updated approach. We propose an Integrated Policy Framework (IPF) diagram to analyze the use of multiple policy tools as a function of shocks and country characteristics. The underlying model features dominant currency pricing, shallow foreign exchange (FX) markets, and occasionally-binding external and domestic borrowing constraints. Our diagram includes the use of monetary policy, FX intervention, capital controls, and domestic macroprudential measures. It has four panels to explore four key trade-offs related to import consumption, home goods consumption, the housing market, and monetary policy. Our extended diagram adds fiscal policy into the mix.

This paper presents an overview of the Ararat Fiscal Strategy Model (AFSM), which is a structural, New-Keynesian, DSGE, small open economy model with a rich fiscal block that includes several expenditure and revenue instruments, and types of debt. The AFSM is now a formal part of the Ministry of Finance analytical toolkit to do macroeconomic fiscal policy scenario analysis, which feeds into policy discussions, budget planning, and the Medium-Term Expenditure Framework. The model was applied to assses the macroeconomic impact of the “first wave” of the Covid-19 pandemic on the Armenian economy, including the mitigating effects of policy responses. AFSM simulations revealed a potential severe impact in 2020, with declines in GDP and consumption of 12.9 and 11.7 percent, respectively, and a cumulative loss of GDP of 38 percent for the period 2020-2023. They also highlighted a significant fiscal outlook deterioration that would increase public debt-to-GDP ratios by 18.8 percentage points over 2020-23. The package of counter-cyclical fiscal measures of 3.6 percent of GDP, however, was estimated to cushion the 2020 GDP decline by almost 2 percentage points, as well as protect jobs. A second AFSM application related to the 2018 public investment under-execution showed the importance of improving the efficiency of public investment to have positive macroeconomic and fiscal effects.

We develop a tractable small-open-economy framework to characterize the constrained efficient use of the policy rate, foreign exchange (FX) intervention, capital controls, and domestic macroprudential measures. The model features dominant currency pricing, shallow FX markets, and occasionally-binding external and domestic borrowing constraints. We characterize the conditions for the “traditional prescription”—relying on the policy rate and exchange rate flexibility—to be sufficient, even if externalities persist. The conditions are satisfied for world interest rate shocks if FX markets are deep. By contrast, we show that to manage non-fundamental inflow surges and taper tantrums related to local currency debt, capital inflow taxes and FX intervention should be used instead of the policy rate and exchange rate flexibility. In the realistic case where countries face both shallow FX markets and external borrowing constraints, we establish that some kinds of FX mismatch regulations may reduce the external debt limit friction but worsen FX market depth. Finally, we show that capital controls and domestic macroprudential measures cease to be perfect substitutes if there is a risk that the domestic borrowing constraint binds as a result of the transmission of the global financial cycle.

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