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| Current Account Shocks, Capital Flow Management and Central Bank Monetary Policy Implementation |
| LIU Yao, ZHANG Ming
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National Academy of Economic Strategy,Chinese Academy of Social Sciences;
Institute of Finance & Banking, Chinese Academy of Social Sciences;
National Institute for Finance & Development |
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Abstract The global economy is currently caught in a conflicting scenario of low growth and high inflation characterized by frequent balance of payments adjustments and abnormal cross-border capital flows. The outbreak of COVID-19 in early 2020 generated additional external shocks that have further exposed the global economy to uncertainties and vulnerabilities and prompted monetary authorities to weigh the effectiveness of various capital flow management tools. The state of the global economy also poses a major challenge to central banks' monetary policy implementation.
The relationship between different countries' current account movements and monetary policy adjustments should not be neglected. When significant adjustments are made to the current account, the supply of base money and the trend of inter-bank lending rates also show huge fluctuations, with the trends of changes appearing completely consistent at certain points. However, further research is needed to determine the extent to which current account adjustments and reversals caused by external shocks have influenced different countries monetary policy implementation since the 2008 global financial crisis. In this paper, we examine how the central banks of different countries that are facing external shocks and that adopt different capital flow management tools determine their optimal monetary policies.
This paper builds a DSGE model of a small open economy with current account shocks and compares the heterogeneous effects of negative current account shocks on monetary policy implementation. We also examine the transmission mechanisms of different capital flow management tools when the central bank implements quantitative monetary policy rules, the CPI inflation-based Taylor rule and the PPI inflation-based Taylor rule. We also conduct a welfare analysis. The main conclusions of this paper are as follows. First, we find that negative current account shocks affect the central bank's monetary policy implementation. Second, capital flow management can impede negative current account shocks and using a combination of price-based capital account management tools and the Taylor rule of targeting PPI inflation can cause less welfare losses. Third, we find that while dual negative shocks on the trade and investment earnings sides of the current account have a significant impact on a country's monetary policy implementation, public expectations of current account deterioration have less impact on monetary policy implementation.
The findings of this paper have a number of policy implications. First, central banks should attach great importance to the adjustment and reversal of the current account, monitor external balances, try to distinguish the sources of negative shocks, implement appropriate remedies and make quick policy adjustments. Second, central banks should seek to enhance their credibility and actively guide the public to have consistent expectations to actively reduce the occurrence of inconsistent dynamic rules. Third, the central banks of transition economies should be open to implementing price-based monetary policy rules. The optimal monetary policy should balance price stability with risk mitigation, moderately reduce the attention to the nominal exchange rate, prudently promote the process of capital account opening, and use price-based capital account management tools to reduce the distortion of social welfare. Finally, central banks should implement and improve the two-pillar framework of monetary and macro-prudential policy, and strengthen the collocation and coordination of macro-policies.
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Received: 26 January 2022
Published: 20 January 2023
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