Marcin Kolasa

We investigate the optimal time-consistent use of foreign exchange interventions (FXI) in a small open economy model driven by endowment and portfolio flow shocks, with endogenous FX market depth and a lower bound constraint on FX reserves. In a competitive equilibrium, large capital flows increase conditional exchange rate volatility and make FX markets more shallow. Unlike in the unconstrained case, the central bank's optimal interventions are not solely targeted at offsetting inefficient fluctuations in the UIP premium but also incorporate a forward-looking element due to the risk of depleting reserves. We show that this environment engenders optimal time-consistent FXI policy that is state-dependent. FX sales are more effective than FX purchases, and the policy may respond less or more than one-for-one to capital outflows, depending on their size and the economy's net foreign asset position. Adopting the policy delivers sizable welfare gains, significantly exceeding those from a simple rule directed at stabilizing current capital flows, but only if the initial level of FX reserves is sufficiently far from its effective lower bound.

Emerging markets have shown remarkable resilience during risk-off episodes in recent years. While favorable external conditions—good luck—contributed to this resilience, improvements in policy frameworks—good policies—played a critical role in bolstering the capacity of emerging markets to withstand the adverse consequences of these events. Improvements in monetary policy implementation and credibility have reduced reliance on foreign exchange (FX) interventions and capital flow management measures, and stricter macroprudential regulation also contributed to less FX interventions. Also, central banks have become less sensitive to fiscal interference and hold sway over domestic borrowing conditions. Looking ahead, countries with robust frameworks face easier policy trade-offs and are better positioned to navigate risk-off episodes. In contrast, economies with weaker frameworks risk de-anchoring inflation expectations and larger output losses if monetary tightening is delayed, especially when persistent price pressures emerge. In these settings, FX interventions offer only temporary relief and are less necessary when policy frameworks are sound.

Quantitative easing (QE) has been criticized for helping fuel the post-COVID inflation boom and causing large central bank losses. In this paper, we argue that QE should be evaluated mainly on its ability to achieve core macro-objectives as well for its effects on the consolidated fiscal position of the government and central bank, although central bank losses can matter to the extent that they may weaken central bank credibility. Using a DSGE model with segmented asset markets, we show how QE can provide a sizeable boost to output and inflation in a deep liquidity trap and can reduce public debt substantially. This contrasts to the rise in public debt that occurs under fiscal expansion and makes QE an attractive tool in a high debt environment. There is more reason for caution in using QE in a “shallow" liquidity trap in which the notional interest rate is only slightly negative: QE runs more risk of causing the economy to overheat, especially if forward guidance has a strong element of commitment, and is more likely to generate sizeable central bank losses. Some refinements in strategy, including the use of escape clauses, can help mitigate overheating risks.

This paper provides a comprehensive assessment of the macroeconomic and fiscal impact of unconventional monetary tools in small open economies. Using a DSGE model, we show that the exchange rate plays a critical role to amplify the favourable impact of unconventional monetary policy while it attenuates the effectiveness of conventional fiscal policy to jointly boost output and inflation. We then use the model as a laboratory to do a case study of the Swedish Riksbank asset purchases and negative policy rates 2015-2019. We find that the Riksbank unconventional policy measures provided meaningful macroeconomic stimulus to economic activity and inflation, with the dual benefit of reducing overall government debt by about 5 percent of GDP. If conventional fiscal policy had been used to provide a commensurate output boost, inflation would have risen notably less, and the fiscal cost would have amounted to a deterioration of the government debt position with nearly 8 percent of GDP.

We develop an extension of the open economy New Keynesian model in which agents are boundedly rational à la Gabaix (2020). Our setup nests rational expectations (RE) as a special case and it can successfully mitigate many “puzzling” aspects of the relationship between exchange rates and interest rates. Since the model implies an uncovered interest rate parity (UIP) condition featuring behavioral expectations, our results are also consistent with recent empirical evidence showing that several UIP puzzles vanish when actual exchange rate expectations are used (instead of realizations implicitly coupled with the RE assumption). We find that cognitive discounting dampens the effects of current monetary shocks and lowers the efficacy of forward guidance (FG), but its relative importance in mitigating the so-called FG puzzle is decreasing in openness. Finally, we show that accounting for myopia exacerbates the small open economy unit-root problem, makes positive monetary spillovers more likely, and increases the persistence of net foreign assets and the real exchange rate.

"Volume 2022 (2022): Issue 012 (Mar 2022): Review of The Institutional View on The Liberalization and Management of Capital Flows — Background Note on Using the IPF Analytical Toolkit to Enhance Policy Assessments" published on 30 Mar 2022 by International Monetary Fund.

"Volume 2021 (2021): Issue 292 (Dec 2021): A Quantitative Microfounded Model for the Integrated Policy Framework" published on 17 Dec 2021 by International Monetary Fund.