The Complementarity of Policy Instruments in an Open Economy Subject to Volatile Capital Flows

Abstract

This paper highlights the complementarity of multiple policy instruments in an open economy subject to volatile capital flows. The central bank operates under a broad mandate and implements optimal policy with discretion. With three policy instruments - the policy rate, an interest equalization measure, and foreign exchange market intervention – the central bank restores the output-inflation trade-off in the canonical closed-economy New Keynesian model. It also achieves perfect stabilization of undesirable hot money flows and insulates the domestic economy from foreign monetary policy and other demand-side shocks.