Optimal Monetary Policy and Capital Account Restrictions in a Small Open Economy

Declines in interest rates in advanced economies during the global financial crisis resulted in surges in capital flows to emerging market economies and triggered advocacy of capital control policies. We evaluate the effectiveness for macroeconomic stabilization and the welfare implications of the use of capital account policies in a monetary DSGE model of a small open economy. Our model features incomplete markets, imperfect asset substitutability, and nominal rigidities. In this environment, policymakers can respond to fluctuations in capital flows through capital account policies such as sterilized interventions and taxing capital inflows, in addition to conventional monetary policy. Our welfare analysis suggests that optimal sterilization and capital controls are complementary policies.