3/2024 Alfred V Guender. Central Bank Stabilisation Policy When Capital Flows Matter: Instruments, Targets, and Trade-offs
Working Papers of Eesti Pank 3/2024
This paper examines how policy instruments shape the trade-off between core macroeconomic and financial stability in an open economy where speculative capital flows affect financial market conditions. We derive and contrast the target rules that underpin optimal discretionary policy in four different instrument scenarios, each of which involves one, two or three of the following instruments: the policy rate, an interest rate equalisation tool, and intervention in the foreign exchange market. The analysis reveals a one-to-one correspondence between the policy instruments deployed and the number of target rules that guide the optimal policy. Using more instruments leads to simpler target rules, sharper trade-offs, and increased welfare. The three-instrument case produces the same output-inflation trade-off as the canonical closed-economy New Keynesian model and ensures complete insulation from foreign monetary policy and other demand-side shocks.
