Appropriate policy tools to manage capital flow externalities

Abstract

Central banks are at the forefront of cyclical policymaking. They therefore become natural candidates to take over all cyclical policy objectives. This is often the case in policies for controlling capital inflows. Giving the duty of controlling capital flows to central banks, explicitly or implicitly, without giving them the appropriate policy tools, leads to inefficient outcomes. It is clear that when a central bank has to use its interest rate tool to satisfy multiple objectives, it will have to make sacrifices. More subtly, but perhaps more importantly, when central banks incur the cost of capital inflows, mostly in terms of taking the public blame, other policymakers often engage in policies that have the side effect of increasing these flows. It then becomes doubly important to give the capital flow management mandate to the policymaker who fosters the inflows, so their possible negative effects will be internalized.