Sudden Stops and the macroprudential role of monetary policy
 

Abstract

We document three key facts about the impact of large swings in capital inflows on emerging market economies. First, large declines (sudden stops) associated with tightening global financial conditions lead to private credit crunches and contractions in economic activity. Second, large increases (surges) in capital inflows predict sudden stops. Third, the effects of sudden stops and surges are independent of the currency composition of external liabilities. 

To account for these stylized facts, we develop a small open economy model characterized by shallow domestic financial markets and occasionally binding leverage constraints. In this framework, capital inflows expand the availability of credit to domestic borrowers but simultaneously hinder the development of the domestic financial sector. When inflows recede, domestic banks face binding leverage constraints, resulting in credit crunches and severe recessions. We derive the optimal monetary policy and isolate its macroprudential component. To reduce the likelihood of sudden stops, the optimal policy deviates from price stability to lean against the accumulation of external imbalances.