The resumption of capital flows to emerging market economies since mid-2009 has posed two interrelated challenges for policymakers: (i) preventing the flows from exacerbating overheating pressures and thereby undermining macroeconomic stability and (ii) minimizing the risk that prolonged periods of easy financing conditions will undermine financial stability. To address these challenges, policymakers have begun using macroprudential measures in addition to monetary policy. This article summarizes recent research on the interaction between monetary policy and macroprudential regulations in managing large capital inflows.

Experience has shown that macroeconomic stability is not a sufficient condition for financial stability. Before the onset of the global financial crisis, relatively stable growth and low inflation in advanced economies had created a deceptive picture behind which financial imbalances had built up. Moreover, microprudential regulation, with its focus on individual financial institutions, was not adequate to avoid system-wide risks. Hence, macroprudential supervision has gained popularity in a number of emerging market economies (IMF, 2011a).

Macroprudential measures are defined as regulatory policies that aim to reduce systemic risks to protect the financial system against shocks (IMF, 2011b). During boom times, perceived risk declines; asset prices increase; and lending and leverage become mutually reinforcing. In principle, macroprudential measures could address the procyclicality of financial markets by making it harder to borrow during a boom, thereby making the subsequent bust less dramatic and mitigating the amplitude of the boom-bust cycle.

Macroprudential measures differ from traditional monetary policy instruments in some key respects. Both changes in policy rates and macroprudential measures are likely to affect aggregate demand and supply as well as financial conditions in similar ways. However, the two instruments are not perfect substitutes. First, the policy rate may be too blunt an instrument, as it impacts all lending activities regardless of whether they represent a risk to the economy (Ostry and others, 2010). By contrast, macroprudential measures are aimed specifically at markets in which the risk of financial stability is believed to be excessive. Second, in countries with open financial accounts, an increase in the interest rate might have only a limited impact on credit expansion if firms can borrow at a lower rate abroad. Third, interest rate movements aiming to ensure financial stability could be inconsistent with those required to achieve macroeconomic stability, and that discrepancy could risk de-anchoring inflation expectations.

It is useful to ask how policy intervention in a private borrowing decision can be justified. The question can be answered in two ways: first, by reference to negative externalities that arise because agents do not internalize the effect of their—often excessive—individual borrowing decisions on financial stability; and, second, by reference to the potential role for macroprudential regulations in mitigating the costs associated with financial crises.

There has been a rapidly growing literature addressing this question using both approaches. For example, Bianchi and Mendoza (2011), among a few others, focus on “overborrowing” tendencies of agents and consequent externalities. In this line of thought, regulations induce agents to internalize the externalities brought by their decision and thereby increase macroeconomic stability. However, “overborrowing” is not a general feature. Benigno and others (2011) find that in normal times, “underborrowing” is much more likely to emerge than is “overborrowing.” Others focus on the interactions between monetary policy and macroprudential measures. Kannan, Rabanal, and Scott (2009), N’Diaye (2009), and Angeloni, Faia, and Lo Duca (2010) incorporate macroprudential instruments into general equilibrium models in which monetary policy has a nontrivial role. However, these papers feature a closed economy and are hence not suitable for an analysis of emerging market countries, or they lack the necessary microfoundations for a thorough analysis.

Unsal (forthcoming) complements the existing literature on the interplay between monetary policy and macroprudential measures by adding an open-economy dimension with a fully articulated financial sector. The objective is to quantitatively assess the ability of alternative monetary and macroprudential responses, as well as capital controls, to manage capital inflow surges. In the model, firms can finance their investment through retained earnings or borrowing from domestic or foreign sources. Macroprudential policy entails higher costs for financial intermediaries that are likely to be passed on to borrowers. Hence, in the model, macro-prudential measures are defined as an additional “regulation premium” to the cost of borrowing, and that premium rises with credit growth. This approach is meant to capture the notion that such measures make it harder for firms to borrow during boom times and therefore make a subsequent bust less dramatic (IMF, 2011c).

The initial shock is modeled as a decline in investors’ perception of risk, and it plays out through the familiar financial accelerator mechanism (Ozkan and Unsal, 2010). As financing costs decline, firms borrow and invest more. Stronger final demand and higher asset prices boost firms’ balance sheets and reduce the risk premium further. As capital inflows surge, the currency appreciates, which helps limit overheating and inflation pressures. Eventually, higher leverage triggers an increase in the risk premium, and financial conditions normalize. However, both monetary and macroprudential policies have a nontrivial role in mitigating the impact of the shock.

The simulations suggest that macroprudential measures could be a useful complement to monetary policy in stabilizing the economy after a financial shock that triggers capital inflows. When policymakers adopt macroprudential measures that directly counteract the easing of the lending standards, the responses of domestic and foreign debt, as well as asset prices, to a surge in capital inflows become more muted.

However, capital controls—macroprudential measures that discriminate against foreign liabilities—are less effective in mitigating the impact of the shock. Naturally, capital inflows are smaller under this scenario, but regulation fails to achieve its very first objective of limiting financial vulnerabilities. The policy essentially generates a shift from foreign loans to domestic loans, leaving aggregate credit growth nearly unchanged. In fact, the welfare losses are considerably higher than in the case of broad-based macroprudential measures.

However, macroprudential responses alone are not sufficient and should not be seen as a substitute for an appropriate monetary policy response. When macroprudential measures, rather than monetary policy, are used to stabilize the economy, demand and inflation will be more volatile than under other policy regimes, and the welfare loss will be excessively large. The reason is that a solely macroprudential approach stabilizes firms’ borrowing and investment but not aggregate consumption, as this type of policy would leave the interest rate constant.

These results support the use of macroprudential policies in macroeconomic policymaking given large capital inflows generated by a positive financial shock. However, a few practical issues remain. For example, whether macroprudential measures could help monetary policy in stabilizing the economy under different type of shocks is not obvious. In fact, Unsal (forthcoming) finds that, in response to a technology shock, which creates a trade-off between macroeconomic stability and financial stability, the positive contribution of macroprudential measures to economic stability becomes negligible.

The transmission mechanism of monetary policy could be impaired during periods of large capital inflows. For example, by depressing local long-term yields, the rapid resumption of capital flows to emerging markets after the global crisis has raised concerns about policymakers’ ability to tighten monetary stances. Jain-Chandra and Unsal (forthcoming) find that global interest rates have been a key driver of long-term bond yields in emerging Asia. However, the interest rate channel of the monetary transmission mechanism remains powerful, as it works mainly through short-term interest rates in Asia (IMF, 2011c).

Moreover, monetary policy can influence the propagation of a financial shock. Focusing on financial and trade channels that have been crucial in the transmission of the recent global crisis to emerging market countries, Ozkan and Unsal (forthcoming) suggest that capital inflows have contributed to the rapid recovery from the crisis in a number of emerging market economies with limited financial contagion from the global economy. They show that, in the absence of financial spillovers from the global economy, an emerging market economy under a fixed exchange rate regime is likely to experience less volatility in investment, consumption, and output compared with an inflation targeting regime. In the presence of financial contagion, however, this result is overturned.

The research summarized above clearly shows that the ongoing integration of capital markets across national borders beckons researchers to pay greater attention to the role of capital flows in shaping macroeconomic outcomes and policy responses. However, the policy debate on these issues is still far from reaching a consensus.