The expansionary lower bound: contractionary monetary easing and the trilemma

UAA

BIS Working Papers

No 770

 

The expansionary lower bound: contractionary monetary easing and the trilemma

by Paolo Cavallino and Damiano Sandri

 

Monetary and Economic Department

February 2019

 

JEL classification: E5, F3, F42

Keywords: Monetary policy, collateral constraints, currency mismatches, carry trade, spillovers

 

This publication is available on the BIS website (www.bis.org).

 

© Bank for International Settlements 2017. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated.

ISSN 1020-0959 (print)

ISSN 1682-7678 (online)

 

The expansionary lower bound: contractionary monetary easing and the trilemma

by Paolo Cavallino and Damiano Sandri

 

Abstract

We provide a theory of the limits to monetary policy independence in open economies arising from the interaction between capital flows and domestic collateral constraints. The key feature is the existence of an “Expansionary Lower Bound” (ELB), defined as an interest rate threshold below which monetary easing becomes contractionary. The ELB can be positive, thus binding before the ZLB. Furthermore, the ELB is affected by global monetary and financial conditions, leading to novel international spillovers and crucial departures from Mundell’s trilemma. We present two models in which the ELB may arise due to either carry-trade capital flows or currency mismatches.

JEL classification: E5, F3, F42

Keywords: Monetary policy, collateral constraints, currency mismatches, carry trade, spillovers

1. Introduction

The large swings in capital flows during the global financial crisis and the concerns about interna­tional spillovers from the ongoing US monetary tightening have rekindled the debate on whether emerging markets (EMs) can retain monetary independence while having open capital accounts. According to Mundell's trilemma, monetary authorities in EMs can respond effectively to global financial and monetary shocks even if they are open to capital flows as long as they allow for ex­change rate flexibility. Under this perspective, which is at the core of conventional open-economy models, movements in capital flows do not undermine the ability of monetary policy to ensure macro-economic stability.

However, growing skepticism against this benevolent view of capital flows has been voiced by both academics and policy makers (Blanchard et al., 2016; IMF, 2012; Obstfeld, 2015; Rajan, 2015; Rey, 2015, 2016; Arregui et al., 2018). These concerns stem in part from the observation that financial and monetary conditions in EMs are strongly affected by volatile international capital flows, raising doubts on whether monetary policy in EMs can effectively balance these pressures. Furthermore, monetary policy in EMs can itself generate swings in capital flows that may impair monetary transmission. For example, policy makers in EMs are often reluctant to lower interest rates during an economic downturn because they fear that, by spurring capital outflows, monetary easing may end up weakening, rather than boosting, aggregate demand.

An empirical analysis of the determinants of policy rates in EMs provides suggestive evidence about the tensions faced by monetary authorities, even in countries with flexible exchange rates. In Table 1, we regress policy rates for a sample of major EMs over Taylor-rule determinants as well as measures of global financial and monetary conditions. The results reveal that, even after controlling for expected inflation and the output gap, monetary authorities in EMs tend to hike policy rates when the VIX or US policy rates increase. This is arguably driven by the desire to limit capital outflows and the depreciation of the exchange rate. These effects are highly statistically significant and economically sizable. Furthermore, they are robust to using quarterly or monthly data, excluding one country at a time, and estimating the regressions in first differences. In this paper we provide a theory that rationalizes how free capital mobility can hinder monetary policy independence in EMs, i.e. it can prevent monetary authorities from ensuring macro-economic stability even under a

Image 49oz

flexible exchange rate regime. This is because the interaction between capital flows and domestic collateral constraints can undermine monetary transmission. More specifically, our theory predicts the existence of an “Expansionary Lower Bound” (ELB) which is an interest rate threshold below which monetary easing becomes contractionary. The ELB constraints the ability of monetary policy to stimulate aggregate demand, placing an upper bound on the level of output achievable through monetary stimulus.

The ELB can occur at positive interest rates and is therefore a potentially tighter constraint for monetary policy than the Zero Lower Bound (ZLB). Furthermore, global monetary and financial conditions affect the ELB and thus the ability of central banks to support the economy through monetary accommodation. A tightening in global monetary and financial conditions leads to an increase in the ELB which in turn can force domestic monetary authorities to increase policy rates in line with the empirical evidence presented in 1.

We establish the conditions for the existence of the ELB in the context of two different models. This shows that the ELB can arise in various environments through the interaction of capital flows and domestic collateral constraints. In the first model the ELB arises because of the impact of mon­etary policy on carry-trade capital flows. The model features a small open economy populated by domestic borrowers and savers, in which collateral constraints take the form of leverage restrictions on the domestic banking sector. Banks collect deposits, invest in government bonds, and provide domestic loans. Government bonds are also held by foreign investors whose demand is increasing in the expected currency risk premium of domestic over foreign assets.

In the model, monetary easing triggers capital outflows since it reduces the excess return on domestic bonds. When the banks’ leverage constraint is not binding, monetary easing has conven­tional expansionary effects as the banking sector can absorb the excess supply of bonds without jeopardizing its ability to provide loans. However, for a sufficiently strong monetary easing, capital outflows become large enough to push domestic banks against their leverage constraint. Once banks are constrained, further monetary easing can become contractionary. This is because to absorb the bonds liquidated by foreign investors, banks have to reduce private credit by increasing lending rates. If this credit crunch is sufficiently large, monetary easing becomes contractionary giving rise to the ELB.

In the second application the ELB arises because of the effects of currency mismatches on collateral constraints. This is a proverbial concern in EMs that in recent years have accumulated large amounts of US dollar debt attracted by low US rates (Acharya et al., 2015; McCauley, McGuire and Sushko, 2015). In the model, unhedged currency mismatches are held by domestic banks that borrow internationally in foreign currency and lend domestically in local currency. As in the first model, banks are subject to a leverage constraint that limits domestic lending to a certain multiple of bank capital.

When the leverage constraint is not binding, monetary accommodation is expansionary. Lower rates boost domestic demand and, by depreciating the exchange rate, they also strengthen foreign demand. However, a sufficiently large monetary easing can make the leverage constraint binding since the exchange rate depreciation reduces bank capital. From this point onward, if foreign- currency debt is sufficiently large, additional monetary easing becomes contractionary since banks can no longer freely intermediate foreign capital to provide domestic loans. This generates an increase in lending rates and a domestic credit crunch that contracts domestic demand and output.

A crucial aspect of our theory is that in both models the ELB is affected by global financial and monetary conditions. Under carry-trade capital flows, the ELB increases with a tightening of global financial conditions since foreign demand for domestic bonds weakens. In the presence of currency mismatches, the ELB rises instead with an increase in the foreign monetary policy rate due to the depreciation of the exchange rate. The increase in the ELB can in turn push EMs into a recession while central banks are forced to increase policy rates, in line with the evidence in Table 1. This is the case even in countries with flexible exchange rates, thus providing a crucial departure from Mundell’s trilemma.

The existence of the ELB gives rise also to a novel inter-temporal trade-off for monetary policy. This is because, unlike the ZLB, the level of the ELB is affected by the monetary policy stance in previous periods through the effects on domestic lending, capital flows, and bank capital. In particular, a tighter ex-ante monetary policy tends to lower the ELB in subsequent periods. This calls for running the economy below potential by keeping a tighter monetary stance to lower the

ELB and allow for greater monetary space in the future. The negative correlation between ex-ante monetary policy and the ELB has the additional implication that monetary policy tends to become less effective in stimulating output even when the ELB does not bind. This is because the stimulative effects of monetary easing are partially offset by the expectation of a tighter future monetary stance due to the increase in the ELB.

The ELB provides also a rationale for alternative policy tools that can be used by domestic au­thorities to regain monetary space, especially unconventional monetary policies, capital controls, and macro-prudential measures. The effectiveness of these tools and the channels through which they operate depend on the determinants of the ELB. Balance-sheet operations by the central bank, including quantitative easing and foreign exchange intervention, are quite effective in overcoming the ELB due to carry-trade flows since they support credit supply by reducing the amount of gov­ernment bonds held by banks. Capital controls are instead helpful in case of currency mismatches, since they can be used to decouple the exchange rate from the domestic monetary conditions. In­terestingly, forward guidance is unable to ease the constraints imposed by the ELB, despite being quite effective in overcoming the ZLB. This is because the ELB is an endogenous interest threshold that increases with the expectation of looser monetary policy in the future.

The paper is structured as follows. After reviewing the relevant literature, we present the model with carry traders in section 2. We then analyze the model featuring currency mismatches in section 3. We summarize key findings and avenues for future research in the concluding section.

Literature review. The idea that domestic collateral constraints can alter the transmission of mon­etary policy is related to the literature spurred by the 1997 financial crisis in East Asia. Despite sound fiscal positions, East Asian countries suffered a severe crisis because the sharp depreciation of their exchange rates impaired the balance sheets of banks and firms with dollar liabilities. This led to the development of a third generation of currency crisis models to explain how the inter­play between collateral constraints and currency mismatches can give rise to self-fulfilling currency runs (Krugman, 1999; Aghion, Bacchetta and Banerjee, 2000, 2001). Particularly related to our paper was the debate on the appropriate response of monetary policy, with some arguing in favor of monetary stimulus to support domestic demand, while others calling for monetary tightening to limit balance-sheet disruptions. These issues are analyzed in Cespedes, Chang and Velasco (2004), Christiano, Gust and Roldos (2004), and Gourinchas (2018). While these models can generate situa­tions in which monetary easing is contractionary, the ability of the central bank to stabilize output is never constrained. Even when monetary easing is contractionary, monetary policy can still achieve any desired level of output by raising rather than lowering policy rates.

The global financial crisis led to renewed interest in how financial frictions can affect monetary transmission. Ottonello (2015), and Farhi and Werning (2016) show that currency mismatches and collateral constraints can considerably complicate the conduct of monetary policy. In these models, monetary easing remains expansionary, but by depreciating the exchange rate it tightens collateral constraints and forces a reduction in domestic consumption. Therefore, monetary policy faces a trade-off between supporting output and stabilizing domestic consumption, even though it can still achieve any desired level of output. The interaction between monetary policy and collateral con­straints is also analyzed in Fornaro (2015), but in a model where monetary easing relaxes domestic constraints.

We go beyond this literature by developing models in which the interplay between collateral constraints and capital flows does not only generate competing objectives for monetary authorities, but it even prevents monetary policy from achieving a unique target, namely output stabilization. This happens because in our models monetary policy itself determines whether collateral constraints are binding or not. This is essential to generate the ELB and thus place an upper bound on the level of output that monetary policy can achieve. Furthermore, while the preceding literature focused only on currency mismatches, we show that monetary policy can face limits in stimulating output also because of the impact of carry-trade capital flows on domestic collateral constraints.

The notion that monetary policy may become ineffective below a certain interest rate threshold is common to other two recent papers. Brunnermeier and Koby (2016) point out that monetary policy can become contractionary because it may impair bank profitability. This can in turn push banks against their leverage constraint at which point further monetary easing can lead to an increase in lending rates. Concerns about the impact on bank profitability are expressed also in Eggertsson et al. (2019), but in reference to the recent adoption of negative policy rates in several advanced economies. Since banks appear reluctant to lower deposit rates below zero, charging negative rates on bank reserve tends to reduce bank profits and lead to a contraction in credit supply. These papers use closed economy models which are therefore silent about the international aspects which are central to our analysis.

The paper is also closely related to a recent literature that analyzes the role of macro-prudential policies and capital controls in open economies, among which for example Jeanne and Korinek (2010), Bianchi (2011), Benigno et al. (2013) Benigno et al. (2016), and Korinek and Sandri (2016). These papers rationalize the use of these policy tools to correct externalities associated with collat­eral constraints in the context of real models. On the contrary, we work with a monetary model in which capital controls and macro-prudential policies are used to overcome the constraints imposed by the ELB. Closer to us, Aoki, Benigno and Kiyotaki (2016) analyze the tensions faced by mone­tary policy because of currency mismatches and the benefits from financial sector policies, but in a model where monetary easing remains expansionary.

We develop the analysis using models with collateral constraints and heterogeneity between constrained and unconstrained agents. The paper is thus related to a growing literature that analyzes monetary policy in models with incomplete financial markets and heterogeneous agents (Auclert, 2016; Gornemann, Kuester and Nakajima, 2016; Kaplan, Moll and Violante, 2016; McKay, Naka­mura and Steinsson, 2016; Guerrieri and Lorenzoni, 2016; Werning, 2015). These models reveal important departures from the monetary transmission in representative agent models. For example, they tend to find a stronger responsiveness of consumption to income effects and uncover novel channels of transmission through redistribution effects. Nonetheless, in all these papers, monetary easing remains expansionary.

Finally, the paper is related to three streams of the empirical literature. One documents that EMs tend to resist large movements in exchange rates by displaying what Calvo and Reinhart (2002) referred to as “fear of floating”. Consistent with this evidence, the ELB can induce monetary au­thorities in EMs to increase policy rates when global financial or monetary conditions tighten, thus leaning against sharp exchange rate movements. A second and more recent group of papers, among which (Bruno and Shin, 2015, 2017; Baskaya et al., 2017; Avdjiev and Hale, 2017), provide evi­dence about the large international spillovers from US monetary policy. These papers find that US monetary policy has pronounced effects on global financial intermediaries and in turn on interna­tional capital flows in line with the mechanisms underpinning our models. Third, our first model is related to the empirical literature that analyzes carry trade capital flows, including Lustig and Verdelhan (2007), Brunnermeier, Nagel and Pedersen (2008), Lustig, Roussanov and Verdelhan (2011), Menkhoff et al. (2012), and Corte, Riddiough and Sarno (2016).

2. The ELB under carry-trade capital flows

In this section, we present a model in which the ELB can emerge because of the effects of monetary policy on carry-trade capital flows. In the model, an interest rate cut reduces the expected excess return on domestic bonds and triggers a capital outflow. If large enough, the capital outflow tightens domestic collateral constraints and causes a domestic credit crunch which reduces aggregate demand and output. Monetary easing becomes therefore contractionary giving rise to an ELB.

2.1 Model setup

The model features a small open economy in which banks collect domestic deposits to provide loans and buy government bonds subject to a leverage constraint. Foreign investors supply funds to the small open economy by purchasing government bonds in proportion to their expected excess return over foreign assets. To ease notation, we present the model in a recursive infinite-horizon formulation. When solving it, we will assume that the model is in steady state from time 2 onward and focus on the equilibrium in the first two periods. We describe the model in its most simple form by considering only the role of conventional monetary policy. In section 2.3, we incorporate fiscal and unconventional monetary policy tools to understand how they can help overcome the restrictions imposed by the ELB.

2.2 Household and corporate sector

The economy is populated by two types of households, borrowers and savers, whose variables are denoted with B and S superscripts, respectively. Borrowers and savers have identical preferences but heterogeneous income streams, such that at time 0 and 1 borrowers are borrowing and savers are saving. Households choose consumption to maximize the inter-temporal utility function

Image ycz9

and allocate spending on Home goods according to PH,tCHt = (1 — a) PtCtl. Similarly, foreign households, denoted with an asterisk, smooth consumption according to 1 = в7t*Et [Pt*Ct*/ {Pt*+1C*+1)] and spend on domestic goods an amount equal to PH,tCH,t = aPt*Ct*. We denote aggregate consumption and income by dropping the household-type superscript, so that Ct = CB + Ct and nt = ПВ + nS.

The production sector is composed of a continuum of monopolistically competitive firms which hire households to produce differentiated varieties of the domestic good. Firms face downward sloping demand curves for their own variety and choose prices to maximize profits. Firms can set different domestic and foreign prices for their goods, so that the law of one price does not have to hold. We allow monetary policy to have real affects in periods 0 and 1 by assuming that the prices of goods sold domestically and abroad are constant and equal to PH and PH, respectively. Without loss of generality we normalize them to 1. We instead assume that prices are fully flexible from time 2 onward so that monetary policy has only nominal effects in the steady-state of the model.

2.3 Banking sector

Domestic banks use their networth Nt and collect domestic deposits to provide loans, buy domestic government bonds Bt, and hold central bank reserves Rt. The balance sheet of the representative bank is given by

Image c51x

where ф > 1 and Я e (0,1), such that government bonds have a lower capital charge than domestic loans. This formulation can capture regulatory requirements that usually provide a preferential treatment to government bonds. Or it can be due to market forces that consider bonds as less risky than loans or more easily recoverable in case of bank failure. More formally, constraint  can be microfounded as the incentive compatibility constraint imposed to bankers by their creditors when
assets have different recovery values. For the leverage constraint to be relevant, we assume that banks cannot issue new equity at time 0 and 1.

Banks act competitively and, since returns on their assets are riskless, they simply choose their balance sheets to maximize period-by-period networth subject to the leverage constraint. A no­arbitrage condition between household deposits and central bank reserves implies that the deposit rate is equal to the policy rate 1tD = It. Lending rates and bond yields can instead increase above the policy rate because of the leverage constraint. The first order conditions with respect to loans and government bonds require that

Image qfmc

If the leverage constraint does not bind, lending and bond rates are equal to the policy rate It , so that any monetary policy change transmits one-for-one to all rates. If instead the constraint binds, the lending rate increases above the policy rate to ensure market clearing in the loan market. This gives rise to a lending spread that impairs the transmission of monetary policy. In fact, as we shall see below, a policy rate cut can even lead to an increase in lending rates so that monetary accommodation has contractionary effects on credit supply. When the leverage constraint binds, bond yields must also increase above the policy rate because of no-arbitrage between loans and bonds. The bond spread is proportional to the capital charge Я in the leverage constraint.

2.4 Foreign investors

The country can attract foreign capital by selling government bonds internationally. We assume that foreign capital is channeled through foreign financial intermediaries that finance the purchase of domestic bonds Bf by borrowing in foreign currency at the rate T*, so that their balance sheet is given by Bf + etB* = 0. These intermediaries earn an expected foreign-currency return equal to

In the spirit of Gabaix and Maggiori (2015), we assume that their intermediation capacity is limited by an

Image t48j

agency friction due to their ability to divert funds. Rather than purchasing government bonds, foreign intermediaries can invest in foreign assets and divert a fraction ytBf of the proceeds, where the parameter yt > 0 controls the severity of the agency friction. Creditors can prevent foreign intermediaries from diverting money by constraining their balance sheets to satisfy the following incentive compatibility condition where the left and right-hand side expressions are the expected foreign-currency return for foreign intermediaries in case they invest in government bonds or divert money, respectively. Since the return

Image mi90

from diverting funds is increasing in the size of the intermediaries' balance sheets, the in­centive

Image nmy2

compatibility constraint is binding. Foreign demand for domestic government bonds is thus increasing in the expected excess return over foreign assets according to

The parameter yt determines the size of the intermediaries’ balance sheets and is therefore an inverse measure of their risk-bearing capacity. The higher is yt, the higher is the required compensation per unit of risk. As yt tTC, foreign demand shrinks to zero on matter the size of the excess return on domestic bonds. Vice versa, as yt 10, the risk-bearing capacity is so high that any expected excess return is arbitraged away. In this case, Uncovered Interest Parity (UIP) holds as lfet/et+1 ^ it*. As we shall see when characterizing the model equilibrium, if yt e (0,1), the demand schedule in equation  generates carry-trade dynamics so that domestic monetary easing triggers capital outflows.

The parameter yt is allowed to be stochastic to capture possible shocks to global liquidity condi­tions that can notoriously affect capital flows to EMs. For example, an increase in yt can reflect a rise in global risk aversion or in the perceived riskiness of EM government bonds. Modeling the exact source of shocks to yt goes beyond the scope of this paper since it does not affect the implications for the ELB.

2.5 Public sector and market clearing

The public sector includes the central bank and the government. The central bank conducts mon­etary policy by setting the rate on reserves, it. To simplify the algebra, we abstract from balance- sheets operations by the central bank, considering the limit for Rt 10. In Section 2.3, we relax this assumption and allow the central bank to use quantitative easing and foreign exchange intervention.

Similarly, we start by assuming that the government simply rolls over the stock of public debt, Bf, that comes due each period

Image vor0

2.6 Model equilibrium

We assume that from time 2 onward the bank leverage constraint does not bind, prices are flexible, and the model is in steady state so that Itв = 1. To ease notation and simplify the solution, we also set в = 1 which implies that in steady state agents spend all their income, P2C2 = П2. We generalize the model results to the case in which в < 1 in Appendix A. The steady-state equilibrium can be easily characterized by considering that spending is also equal to the level of money supply, so that P.C2 = M2 . Using market clearing, which equates aggregate income in the Home economy with spending on Home goods, П2 = (1 — a)M2 + e2aM2, we can derive the steady-state level of the exchange rate, which is given by

Image 1d4

Without loss of generality, we normalize the steady-state money supply to 1 in both countries, such that e2 = 1.

In the next section, we characterize the equilibrium in period 1, solving for the conditions under which the ELB may arise and showing how the ELB is affected by global conditions. We will then solve for the equilibrium at time 0, assuming that the bank leverage constraint does not bind and that global intermediaries can freely intermediate foreign funds under y0 i 0. This allows us to analyze how monetary authorities should set policy rates in tranquil times taking into account the possibility that the ELB may become binding in the future.

2.7 Model equilibrium at time 1

The level of domestic output at time 1 is determined by the consumption of home goods by domestic and foreign households. Using a2 to denote the share of steady-state output which is appropriated by borrowers, ю2 = П|/П2, output can be expressed as

The first term on the right-hand side captures the consumption of domestic households, where the lending and deposit rates control the consumption of borrowers and savers, respectively. The second term on the right-hand side represents foreign demand which is not affected by the domestic policy rate because export prices are sticky in foreign currency.

Consider first the model implications if the bank leverage constraint does not bind, so that the lending rate is equal to the policy rate If = I1. In this case, a policy rate cut not only increases savers' consumption by lowering deposit rates, but it also stimulates borrowers' consumption by reducing lending rates. Hence, monetary easing is expansionary, as it raises domestic demand and output.

The effect of a reduction in the policy rate on capital flows is less clear-cut. On the one hand, monetary easing boosts import consumption, thus leading to an increase in the demand for foreign funds holding the exchange rate constant. On the other hand, monetary accommodation reduces bond yields since If = I\ and thus curbs the supply of foreign capital for a given level of the ex­change rate. To restore equilibrium in the market for foreign funds, the exchange rate must neces­sarily depreciate. The effect on capital flows depends on the magnitude of the depreciation or, more specifically, on the elasticity of the exchange rate with respect to the policy rate. If the elasticity is larger than one, a reduction in the policy rate causes a proportionally larger depreciation of the exchange rate which increases the expected excess return on domestic bonds and attracts more in­flows. If instead the elasticity is lower than one, a policy rate cut reduces the return of domestic bonds and therefore triggers capital outflows.

If the bank leverage constraint does not bind, the elasticity of the exchange rate with respect to the policy rate is given by

Image 3o1s

where Bf = BfI0 are the government’s foreign liabilities at the beginning of time 1. This expression shows that in our model, that assumes unitary elasticities of inter and intra-temporal substitution, the effect of monetary policy on capital flows depends on the sign of the current account which is equal to the net repayment of foreign debt, Bf — Bf. If the country is running a current account deficit, the elasticity of the exchange rate is larger than one. In this case, monetary easing generates capital inflows, as it leads to a further deterioration of the current account. If the current account is instead in surplus, a reduction in the policy rate triggers capital outflows.

In turn, the current account crucially depends on global financial conditions captured by y1. Provided that the country enters period 1 with foreign debt, Bf > 0, a higher y1 raises international borrowing costs and induces the country to deleverage by running a current account surplus. This lowers the elasticity of the exchange rate to the domestic policy rate, so that monetary easing gener­ates capital outflows. The effects of y1 on the current account and thus on the elasticity are reversed if the country is a net debtor, BF < 0.10

The model can transparently illustrate the impact of monetary policy on capital flows since it allows for a closed-form solution of foreign bond holdings at the end of period 1. By equating demand and supply of foreign capital, we obtain:

Equation 10 shows that, in our setting, monetary easing increases capital outflows, i.e. it reduces BF, as long as the country is a net debtor and y1 is strictly positive. As explained above, this is because in equilibrium a reduction in the domestic interest rate reduces the foreign-currency return of domestic bonds.

Image qtry

If banks are unconstrained, the capital outflows triggered by monetary easing do not impair monetary transmission. Domestic banks absorb the bonds sold by foreigners by increasing leverage without crowding out lending to the private sector. Banks finance the higher leverage by collecting more domestic deposits. This is possible since in equilibrium the deposit supply increases thanks to the expansionary effects of monetary policy on output and the increase in export revenues as­sociated with the depreciation of the exchange rate. Therefore, when the leverage constraint does not bind, foreign financing can be freely substituted with domestic financing without impairing the transmission of monetary policy.

However, monetary easing can eventually push banks against their leverage constraint as they continue to increase their holdings of government bonds while foreigners pull out. The speed at which bank leverage increases in response to a reduction in the domestic policy rate depends not only on the size of capital outflows, but also on the effect of monetary easing on loan demand, which is equal to

Image w5iv

where L1 = L0If is the outstanding stock of loans at the beginning of time 1. Monetary easing has ambiguous effects on loan demand. On the one hand, it stimulates borrowers’ consumption, n^/lf, by lowering lending rates. On the other hand, it raises borrowers’ income, nf, by boosting output and export revenues. If the former effect is stronger, monetary easing raises loan demand which in turn accelerates the increase in bank leverage. If instead, borrowers’ income increases faster than consumption, monetary easing reduces the equilibrium level of lending, slowing down the increase in leverage.

To focus on the role of capital flows in affecting bank leverage and to allow for an analytical solution of the model, we assume that monetary policy has neutral effects on loan demand by setting nf = —i/I1. This ensures that borrowers have a constant discounted value of income over time so that they simply roll over their outstanding debt. Hence, their demand for credit does not respond to monetary policy. Under this assumption, monetary easing moves banks towards their leverage constraint by increasing their holdings of government bonds while lending to the private sector remains constant, L1 = L1.

Using equations 7, 11, and 3, we can show that the leverage constraint is slack if and only foreigners purchase a sufficiently high level of domestic bonds where the variable  = Bf — (фN1 — L1) /X is the country’s capital shortfall. This is the minimum

amount of foreign capital which is needed to satisfy the domestic demand for credit by the private and public sectors, L1 + Bf at the prevailing policy rate. The bank leverage constraint limits the financial capacity of the country, that is its ability to collect deposits and transform them into credit. Thus, the country needs to attract foreign capital to absorb part of the public debt so that banks can supply enough credit to the private sector. Foreign capital is crucial because of the imperfect substitutability between domestic deposits and foreign funds. Deposits absorb financial capacity since they need to be intermediated by banks before they can be used to finance loans or government bonds. Foreign capital can instead directly fund government bonds without requiring domestic financial intermediation. We assume that the country’s capital shortfall, , is bounded between
(0, lf) which is required for the leverage constraint not to be always or never binding, irrespective of monetary policy.

By generating capital outflows and thus forcing a replacement of foreign funds with domestic funds, monetary easing moves banks towards their leverage constraint. The policy rate level at which the leverage constraint becomes binding is given by

Image mqff

We refer to this interest rate threshold as the Expansionary Lower Bound. The higher the country’s capital shortfall, the higher is the ELB since bonds have to pay a higher yield to attract sufficient capital inflows. The ELB is also increasing in the tightness of global financial conditions, captured by Yi, as foreigners demand higher compensation to hold government bonds. In fact, if global finan­cial conditions are tight enough, the ELB occurs at positive interest rates, /ELB > 1, thus acting as a stronger constraint to monetary policy than the Zero Lower Bound. The ELB is instead declining in the foreign holdings of bonds at the beginning of time 1, if. This is because a higher level of external debt depreciates the exchange rate which raises the foreign-currency return on domestic bonds and increases capital inflows.

If monetary easing continues below /ELB, the economy experiences a credit crunch. Capital inflows are insufficient for banks to satisfy the domestic credit demand at the prevailing policy rate. Therefore, lending rates and bond yields have to increase above the policy rate, undermining the transmission of monetary policy. Their behavior can be characterized by considering the following equation which ensures that the level of foreign bond holdings, on the left-hand side, is consistent with the domestic leverage constraint, on the right-hand side:

Image t4r

This derivative is less than one, capturing the fact that, when banks are constrained, the lending rate rises above the policy rate. In fact, if global financial conditions are sufficiently tight, the derivative turns negative. In this case, monetary easing leads to an increase in the lending rate, as illus­trated in the left chart of Figure 1. Bond yields also increase above the policy rate because of the no-arbitrage condition between loans and bonds. However, monetary easing continues to reduce bond yields and trigger capital outflows even below the ELB. In turn, capital outflows lead to the crowding out of domestic credit as lending rates increase. As previously discussed, this is be­cause the leverage constraint creates a segmentation in financial markets that prevents the domestic economy from substituting foreign financing with domestic savings. The imperfect substitutability between domestic and foreign funds is the fundamental force that undermines monetary transmis­sion and generates the ELB.

Image vj4v

By leading to an increase in lending rates once banks are constrained, monetary easing reduces borrowers' consumption. Nonetheless, monetary easing continues to stimulate savers' consumption since deposit rates decline in line with the policy rate. The ELB exists when the former effect prevails, so that monetary easing generates a contraction in aggregate demand and output. Formally, by differentiating equation (8), we can show that, once banks are constrained, monetary easing becomes contractionary if Intuitively, this condition requires that the increase in lending rates in response to monetary easing, which

Image 9wvm

is controlled by global financial conditions y1, should be sufficiently strong relative to the share of aggregate demand arising from savers, 1 — ю2.

If condition 14 is satisfied, the relationship between the domestic policy rate and output is non­monotonic, as shown in the right chart of Figure 1. The central bank is thus unable to raise output above the level associated with the ELB, which is given by

Image decs

as both a reduction and an increase in the policy rate around leads to a contraction in aggregate demand. The ELB limits the ability of the central bank to stimulate aggregate demand and constrains the conduct of monetary policy. If the level of output targeted by the central bank is below Y^f, the ELB is not binding. However, if the desired level of output is above Yj^, the optimal policy is to set the interest rate at /ELB to stimulate output as much as possible. The central bank would never want to lower the policy rate below /ELB since this would reduce output.

The existence of the ELB generates crucial departures from Mundell's trilemma since it can prevent monetary authorities from stabilizing output in response to global financial and monetary shocks. This is illustrated in Figure 2. The left chart considers the implications of changes in global financial conditions. In line with Mundell’s trilemma, if banks are unconstrained, an increase in y1 does not affect output since the shock is entirely absorbed through a depreciation of the exchange rate. However, by triggering capital outflows an increase in y1 raises the ELB and lowers the max­imum attainable level of output, as shown respectively in equations (12) and (15). If Y#^ falls below the desired level of output, the ELB becomes a binding constraint, forcing the central bank to increase rates and accept a decline in output. This result is consistent with the empirical evidence provided in Table 1, whereby emerging markets tend to hike rates when the VIX increases.

Image jmal

 Model equilibrium at time 0

In this section, we characterize the model equilibrium at time 0 to analyze the implications of the ELB for the ex-ante conduct of monetary policy. More specifically, we want to explore if and how the possibility that the ELB may arise in the future affects monetary policy decisions in earlier periods. We assume that at time 0 domestic and international financial conditions are favorable so that monetary policy operates in a conventional manner. Formally, we assume that the bank leverage constraint does not bind and we take the limit for y0 i 0. In this case, UIP holds and foreign investors are willing to supply any amount of capital that the country requires.

We assume that the only stochastic element at time 1 is the realization of the parameter which follows a binary distribution. With probability p, 71 is sufficiently high to make the ELB a binding constraint for the central bank, thus forcing the monetary authority to set /1 = /fLB. With probability 1 — p the realization of y1 is low, zero for simplicity, in which case the central bank is unconstrained and sets the time-1 policy rate at a certain optimal level /0pt. We also assume that borrowers have no income at time 0, П® = 0, so that they necessarily accumulate debt in this period.

How does monetary policy at time 0 affect monetary space at time 1, i.e. the level of the ELB? To answer this question, we need to understand how the policy rate /0 affects the ratio Bf/Bf, which determines the ELB according to equation (12). By diving both terms by /0, the ratio can be written as

Image 9rg0

where we used = BG/э and N1 = N0/0 since the bank leverage constraint does not bind at time 0.

Therefore, time-0 monetary policy affects the ELB through the impact on capital inflows, Bf, and domestic lending, L0, which are given by

Image vmm6

To understand the impact of time-0 monetary policy on and L0, start by holding constant the expected policy rate and exchange rate at time 1. It is then easy to see that a tightening in monetary policy at time 0 reduces both capital inflows and domestic lending. The reduction in capital inflows tends to raise the ELB since it implies a lower stock of external debt at time 1 and thus a more appreciated exchange rate which reduces foreign demand for government bonds. On the contrary, the reduction in domestic lending tends to lower the ELB since it allows banks to absorb more government bonds at time 1 given their leverage constraint. The overall impact on the ELB thus depends on the balance between these two effects.

Taking now into account also the effects that time-0 monetary policy has on the expected policy rate and exchange rate at time 1, the overall impact of I0 on the ELB is proportional to the following expression

As shown in Appendix A, the above expression implies that a monetary tightening at time 0 lowers the ELB at time 1. The policy rate at time 0 is thus negatively correlated with the level of the ELB at time

Image la96

This gives rise to a novel inter-temporal trade-off for monetary policy since when choosing policy rates at a given time, monetary authorities should be mindful about the implications for the ELB in the future. More specifically, the negative association between the ELB and ex-ante policy rates calls for keeping a somewhat tighter monetary stance when financial conditions are supportive - thus running the economy below potential - to lower the ELB and generate more monetary space in the future.

The negative association between I0 and the ELB has also important implications for the effec­tiveness of monetary policy in periods when the ELB does not bind. In particular, monetary policy at time 0 becomes less powerful in stimulating output which is equal to

Image dz5n

This is because a reduction in I0, by raising the ELB, generates an expected tighter monetary stance in the future, E0 [I1], which weakens the impact on output. Therefore, the ELB not only constraints monetary policy when it binds, but it also hinders monetary transmission when global financial conditions are supportive and banks are unconstrained.

2.8 Policies to escape the ELB

In this section we expand the model to include a broad range of policy tools that may help over­come the ELB. We consider both fiscal policy and capital controls that imply the following budget constraint for the government

Image k40p

where Tt are lump-sum taxes on domestic households and xt is a tax on foreign capital inflows. Furthermore, we analyze the effects of changes in the balance sheet of the central bank which is given by

Image 1i7b

where NfB is networth, Rt are domestic reserves, BfB are holdings of government bonds, and Xt are foreign reserves. Finally, we consider the impact of a recapitalization of the banking sector and of forward guidance, captured in the model through changes in the steady-state level of money supply M2. We analyze primarily the effects of these tools at time 1 when the ELB binds, but also consider how some of them can be used preemptively at time 0. We discuss the results in intuitive terms referring the reader to Appendix A for formal derivations.

Regarding fiscal policy, since the ELB arises because public debt crowds out private lending, it may seem obvious that an increase in government taxes to reduce debt should alleviate the ELB. However, this is not necessarily the case since a tax-based fiscal consolidation has two effects. On the one hand, the reduction in public debt relaxes the bank leverage constraint in proportion to the capital requirement Я. On the other, a tax increase raises loan demand because of a Ricardian equivalence effect: despite higher taxes at time 1, borrowers want to maintain the same level of consumption by borrowing more. The aggregate demand for loans thus increases by the tax burden imposed on borrowers, TtB/Tt, for each unit of additional tax revenues. If TtB/Tt > Я, a tax-based fiscal consolidation ends up tightening collateral constraints, raising the ELB, and lowering output.

Fiscal consolidation can also be undertaken by taxing foreigners with a levy on capital inflows, Xt . However, this reduces foreign holdings of government bonds, forcing banks to further curtail private lending to finance public debt. To lower the ELB, it is instead optimal to subsidize capital inflows, setting Xi < 0. This entails an increase in public debt, but the effect is overall positive, lowering the ELB.

The model has also rich implications for the role of balance-sheet operations by the central bank. The need to relax bank leverage constraints provides a rationale for quantitative easing which involves the purchase of government bonds by the central bank B^ against the increase in central bank reserves R1. By doing so, the central bank acts as a financial intermediary for government bonds, thus releasing liquidity to the banking sector that can be used to extend credit to the private sector. Quantitative easing is thus an effective tool to lower the ELB and stimulate output. Note that this is the case even if part of the gains from quantitative easing are eroded by the actions of carry traders, since by lowering yields on government bonds, quantitative easing exacerbates capital outflows.

The central bank can also alleviate the ELB by engaging in unsterilized foreign exchange in­tervention. By purchasing foreign reserves X against domestic reserves Ri, the central bank can depreciate the exchange rate, increase the expected return of government bonds for foreigners, and thus stimulate capital inflows. Finally, the central bank can also intervene through sterilized for­eign exchange intervention, by selling foreign reserves and buying government bonds in line with Cavallino (2016). This operation can be seen as combining unsterilized intervention (selling FX reserves to reduce domestic reserves) with quantitative easing (increasing domestic reserves to buy bonds). In equilibrium, the latter effect prevails, so that sterilized intervention relaxes the ELB if the central bank reduces foreign reserves, despite the appreciation of the exchange rate.

Turning to forward guidance, this tool is quite effective in providing stimulus when the economy is at the ZLB, as for example discussed by (Krugman, Dominquez and Rogoff, 1998; Svensson, 2003; Eggertsson and Woodford, 2003). A pledge by the central bank to provide stronger monetary stimulus in the future can indeed increase current domestic spending. Does this logic apply also to the ELB? The answer is no because, unlike the ZLB, the ELB is an endogenous interest rate threshold that moves itself with forward guidance. An increase in M2 does increase time-1 spending for a given policy rate 11, but it also increases the ELB. This is because higher M2 leads to a stronger depreciation of the exchange rate at time 2 than at time 1, thus reducing the foreign-currency return on domestic bonds and generating capital outflows. In the model, the overall effect of forward guidance is to increase the ELB, while leaving the level of output at the ELB unchanged.

A policy tool that is instead very effective in overcoming the ELB is the recapitalization of the banking sector, as also analyzed in Kollmann, Roeger and in't Veld (2012) and Sandri and Valencia (2013). This is true even if the recapitalization is financed with lump-sum taxes on borrowers which can be captured in the model through an increase in loan repayments at the beginning of period 1, L1. This is because while lump-sum taxes increase one-to-one loan demand by borrow­ers, they increase lending supply by a greater factor thanks to bank leverage, i.e. ф > 1. A bank recapitalization can thus lower the ELB and allow for greater monetary space.

For what concerns preemptive intervention at time 0, fiscal consolidation has similar effects than at time 1. In particular, fiscal consolidation can lower a future ELB only if the tax burden imposed on borrowers is smaller than the capital charge on government bonds, i.e. T0B/T0 < X. Taxes on capital inflows have instead ambiguous effects. On the one hand, they reduce public debt, thus lowering the ELB. On the other hand, they reduce capital inflows, thus raising the ELB. The overall effect depends on the parameters of the model and in particular on the probability that the ELB may bind in the future. Finally, if y0 > 0 as in Appendix A, foreign exchange intervention can also be helpful at time 0 since it can lower the ELB by depreciating the exchange rate and attracting more inflows.

3. The ELB and currency mismatches

In this section we present a second model to show that the ELB can also emerge because of the expo­sure of the domestic financial sector to currency mismatches. By depreciating the exchange rate, monetary easing reduces bank networth and tightens leverage constraints, possibly leading to a do­mestic credit crunch and output contraction. As in the previous model, this gives rise to an ELB that places an upper bound on the level of output achievable through monetary accommodation. Others papers, in particular Cespedes, Chang and Velasco (2004), Christiano, Gust and Roldos (2004), and more recently Gourinchas (2018), already developed models in which collateral constraints associ­ated with currency mismatches can generate contractionary effects from monetary easing. However, in those models monetary policy can still achieve any level of output since it does not affect whether constraints are binding or not. When constraints bind, monetary policy can indeed increase output without bounds by simply raising policy rates as much as needed. This is no longer possible in our framework, since monetary policy affects whether constraints bind or not. In particular, raising rates eventually makes leverage constraints no longer binding, at which point further interest rate hikes become contractionary.

3.1 Model setup

We consider again a small open economy in which households consume domestic and foreign goods. All households are now borrowers and raise domestic currency loans from local banks as described in the previous model. The corporate sector also mirrors the previous model, except that we now assume that foreign prices are sticky in local currency in period 0 and 1, PH t = PHlet for t = {0,1}. This leads to an additional expenditure-switching channel through which monetary policy stimulates demand for home goods by depreciating the exchange rate.

Unlike the previous model, we dispense from carry-trade capital flows by ruling out frictions in international financial markets so that UIP holds. Furthermore, we assume that banks finance

themselves internationally by issuing foreign-currency debt. The balance sheet of the banking sector is thus given by

Image 8cpz

Image h22y

Image dlog

with ф > 1. We abstract from the role of government debt by assuming that Я = 0.

Banks take interest rates as given and choose assets and liabilities to maximize networth. No arbitrage between central bank reserves and foreign currency debt implies the UIP condition, Et [(et1t — et+11t*) (1t+1 + ф/it+1)] = 0, where ^t+1 is the shadow cost of the leverage constraint. Fur­thermore, the first order condition with respect to domestic lending implies lj+1 > It. If the leverage constraint is not binding, the domestic lending rate is equal to the policy rate. If instead the con­straint binds, the lending rate has to increase above the policy rate to equalize the demand for loans with the constrained supply level. The central bank conducts monetary policy by setting the interest rate on reserves. As in the previous model, we first abstract from the central bank's balance sheet by considering the limit of the model for Rt Я 0.

3.2 Model equilibrium

The solution approach follows the one in the previous model. We assume that the economy is in steady-state from time 2 onward and that nominal spending is equal to money supply, in which case the exchange rate is pinned down by domestic and foreign money supply, e2 = M2/M2*. We first characterize the conditions for the existence of the ELB at time 1 and then analyze the implications for monetary policy at time 0.

3.3 Model equilibrium at time 1

The level of output at time 1 is equal to

Image 39n2

The first and second terms on the right-hand side capture nominal spending on home goods by domestic and foreign households, respectively. If banks are unconstrained, so that the lending rate is equal to the policy rate,  = /1, monetary easing stimulates output through two channels. First,

it boosts spending by domestic households by reducing lending rates. Second, it raises foreign demand through the depreciation of the exchange rate which is equal to e1 = /* //1.

Because of currency mismatches, the exchange rate depreciation caused by monetary easing leads to an erosion of bank networth which is given by

Image 1n5d

where L1 = L010 and D1 = Do/* are the loans and foreign-currency liabilities of the banking sector at the beginning of time 1. The networth loss leads to a tightening of the collateral constraint (16) that becomes binding for a sufficiently low domestic policy rate. Once the leverage constraint binds, banks lose the ability to freely intermediate foreign capital into domestic lending. Indeed, further monetary easing forces banks to reduce domestic lending as the economy experiences capital outflows. To preserve equilibrium in the credit market, the lending rate has to increase above the policy rate to satisfy

Image e1s6

The expression above shows that, when banks are constrained, monetary easing by depreciating the exchange rate may lead to an increase, rather than a decline, of the lending rate. On the one hand, the depreciation reduces credit supply through its impact on bank networth. On the other hand, it reduces credit demand by raising export revenues. If the former effect prevails, which occurs when foreign-currency debt is high enough to satisfy фD1 > — //*, the lending rate has to increase with monetary easing to preserve market clearing.

The increase in the lending rate, in turn, leads to a contraction in domestic spending. This negative effect on domestic demand has to be compared with the positive effect that monetary easing retains on foreign demand through the depreciation of the exchange rate. By plugging equation 18 into equation 17 we can show that the contractionary effect on domestic spending outweighs the expansionary effect on foreign demand if foreign-currency debt is sufficiently high to satisfy

Image by7u

When this condition is satisfied, once the leverage constraint binds, monetary easing becomes con­tractionary giving rise to the following ELB

Image 921v

which prevents the central bank from increasing output above YE! = 1/lfLB.

The level of ELB depends on the extent of currency mismatches on banks’ balance sheets, cap­tured by the proportion of foreign-currency debt relative to domestic-currency loans. If mismatches are severe enough, the ELB can occur at positive interest rates, thus acting as a stronger constraint for monetary policy than the ZLB. Unlike the previous model, the level of ELB is now affected by global monetary conditions. An increase in the foreign policy rate depreciates the domestic cur­rency, rises the ELB, and reduces the maximum level of output that monetary policy can achieve. This is illustrated in Figure 3. If collateral constraints are not binding, changes in foreign monetary policy do not affect domestic output since they are offset by exchange rate movements. This is an implication of Mundell’s trilemma whereby exchange rate flexibility insulates the country from foreign monetary conditions. Note that this is true even in the presence of currency mismatches, but only as long as constraints do not bind. However, by depreciating the domestic currency, an increase in foreign policy rates leads to an erosion in bank networth that tightens collateral constraints and raises the ELB. Therefore, for a large enough increase of the foreign policy rate, the ELB becomes binding and forces the domestic central bank to raise policy rates in line with the empirical evidence presented in Table 1.

Image 2rke

3.4 Model equilibrium at time 0

We now analyze the model equilibrium at time 0 under the assumption that the bank leverage con­straint does not bind. This allows us to analyze how the possibility that the ELB may bind in the future affects monetary policy when financial conditions are favorable. In doing so, we assume that the only stochastic element at time 1 is the foreign monetary policy rate Ifwhose probability distri­bution can be left unspecified for the purpose of our analysis. If the realization of If is sufficiently
low that the ELB does not bind, the domestic monetary authority can maintain output at a certain optimal level, YHi, by setting the policy rate at I[pt = 1/YH\. If instead Ijis high enough that the ELB increases above I^pt, the central bank finds it optimal to set the policy rate at the ELB, lfLS. As shown below, to account for important transmission channels of monetary policy linked to currency mismatches, we allow the domestic inter-temporal discount factor at time 0, во, to possibly differ from one.

Consider first how monetary policy at time 0 affects the ELB at time 1. To do so, we need to understand the impact on the balance sheets of the banking sector at time i. The equilibrium levels of foreign-currency debt and domestic-currency loans at the beginning of time 1 are given by where the parameter 8 = 1 /в0 — 1 captures the impatience of domestic households relative to for­eign

Image id3

agents. To understand the impact of time-0 monetary policy, start by holding constant the expected domestic interest rate at time 1, E0 [I1]. In this case, a domestic monetary tightening at time 0 increases the loan repayments for banks at time 1, L1, since it leads to higher lending rates. At the same it does not generate an increase in foreign-currency debt, D1, which is insensitive to movements in the domestic policy rate. Therefore, monetary tightening at time 0 leads to a reduc­tion in the time-1 ELB as defined in equation (20). If 8 > 0, the impact on the ELB is magnified once we take into account the effects that monetary policy at time 0 has on E0 [I1 ]. The first-round reduction in the ELB leads indeed to a decline in the expected level of the time 1 interest rate, E0 [I1] which in turn increases loan demand at time 0 as shown in equation (22). This raises loan repayments at the beginning of time 1 and further lowers the ELB.

As in the model with carry-trade capital flows, the negative correlation between the time-0 policy rate and the time-1 ELB generates an inter-temporal trade-off for monetary policy. Greater easing at time 0 reduces the space for monetary stimulus in the future by raising the ELB. This calls for keeping a tight domestic monetary stance when global monetary conditions are favorable to have more monetary space to absorb a future foreign monetary tightening. Furthermore, the negative correlation between ex-ante monetary policy and the ELB tends to weaken the transmission of monetary policy even when the ELB does not bind. To see this, note that time-0 output is given by

Image k6lq

where the exchange rate is e0 = /0Eo [/f] / (/0E0 [/1]). The stimulative effect of a policy rate cut at time 0 is partially offset by an expected tightening of future monetary policy E0 [/1] due to the increase in the ELB. This weakens the impact on domestic demand since current consumption depends not only on the current interest rate, but also on the expected future monetary stance. Furthermore, the increase in E0 [/1] reduces foreign demand since it limits the depreciation of the time-0 exchange rate e0.

The current model where the ELB is due to currency mismatches rather than carry-trade flows, provides also interesting insights about the ongoing debate on whether central banks in major ad­vanced economies, notably the Fed, should internalize the effects of their monetary policy decisions on EMs. As shown in Figure (3), a tightening in the foreign policy rate increases the ELB and can push EMs into a recession. This seems to suggest that if foreign central banks care about global welfare, they should refrain from increasing rates sharply when the ELB binds in EMs. For exam­ple, if currency mismatches are associated with US dollars, the Fed should accept some overheating in the US to limit the adverse effects that a sharp monetary tightening would impose on EMs.

Note, however, that if the Fed is expected to follow this course of action, EMs have a perverse incentive to accumulate more foreign-currency debt. As shown in equation (21), foreign liabilities are indeed inversely proportional to the expected tightness of foreign monetary policy E0 [If] if EMs are relatively impatient, so that 5 > 0. The model can therefore rationalize the growing concerns that EMs may be unable to insulate themselves from US monetary conditions, even if they have flexible exchange rates. However, it also shows that any commitment by the Fed to refrain from sharp policy rate increases to help EMs would be partially ineffective because it would led to an endogenous increase in foreign-currency borrowing.

There are two ways to limit this accumulation of additional foreign-currency debt. First, the expectation of a looser US monetary stance if the ELB binds in EMs could be offset with the promise of a tighter US monetary stance if the ELB does not bind. Doing so would prevent a reduction in the expected tightness of future US monetary policy E0 [/f] and thus avoid incentives for additional borrowing. Note that this policy implies a commitment by the Fed to keep a more stable US dollar, hiking policy rates by less when the US economy overheats and cutting them more moderately when the economy contracts. Second, policy makers in EMs can avoid additional foreign-currency debt by adopting macro-prudential regulations. The role of these tools and other policies is analyzed in the following section.

3.5 Policies to escape the ELB

In this section, we consider several policy tools that can be used to escape the ELB. As in the model with carry-trade capital flows, forward guidance is unable to deal with the ELB even it arises from currency mismatches. This is because the promise of a looser future monetary stance leads to an immediate depreciation of the exchange rate that tightens the bank leverage constraint. Formally, an increase in M2 through forward guidance raises the ELB, while leaving the upper bound on the level of output attainable through monetary policy, YHELlB, unchanged. Balance-sheet operations by the central bank are also ineffective in this model since the exchange rate is pinned down by the UIP condition and not by quantity conditions.

The relax the ELB in the presence of currency mismatches, policy markers can rely on the recapitalization of the banking sector which relaxes collateral constraints. Capital controls can also be effective since they can sever the link between the exchange rate and domestic monetary conditions. In particular, the government can stimulate capital inflows and support the domestic exchange rate by providing banks with a subsidy Xi on foreign currency debt. This places a wedge in the UIP condition, eL = e2(1 — Xi)1i /А, that leads to an appreciate of the exchange rate, relaxes the ELB, and allows for greater monetary stimulus. The model provides also a rationale for macro­prudential capital controls that can be put in place in anticipation of the ELB becoming binding. As shown in Appendix B, by taxing capital inflows at time 0, policy makers can effectively reduce the amount of foreign currency debt carried into period 1. This lowers the time-1 ELB, /fLB, and allows for a higher level of output.

4. Conclusion

In this paper, we provided a theory of the limits to monetary policy independence in open economies arising from the interaction between international capital flows and domestic collateral constraints. The key insight is that monetary policy can be constrained in its ability to stimulate output because of the existence of an Expansionary Lower Bound (ELB) which is an interest rate below which monetary easing becomes contractionary. The ELB places an upper bound on the level of output achievable through monetary policy and can thus prevent monetary authorities from responding effectively to global shocks. A tightening in global liquidity or monetary conditions may indeed raise the ELB and push emerging markets into a recession while central banks are forced to raise policy rates in line with the empirical evidence. Crucially, this is the case even in countries with flexible exchange rates, thus leading to crucial departures from Mundell’s trilemma.

We showed that the conditions for existence of the ELB can be met under various circumstances, whenever monetary easing leads to a negative interaction between capital flows and collateral con­straints. The ELB can for example arise because of carry-trade capital flows. In this case, monetary easing determines an outflow of capital which requires the domestic banking sector to absorb the bonds liquidated by foreign investors. This pushes banks against their leverage constraints and even­tually forces them to reduce domestic credit. If the elasticity of capital flows to the domestic interest rate is sufficiently high, the credit crunch is so severe that monetary easing becomes contractionary, giving rise to the ELB.

Monetary policy can face an ELB also in the presence of currency mismatches. If the banking sector borrows abroad in foreign currency and lends domestically in local currency, monetary easing reduces bank networth and moves banks closer to their leverage constraint. Once the constraint binds, further monetary easing forces banks to reduce domestic credit and becomes contractionary if currency mismatches are sufficiently severe.

The models highlight a novel inter-temporal trade-off for monetary policy since the level of the ELB is affected by the past monetary stance. Tighter ex-ante monetary conditions tend to lower the ELB and thus create more monetary space to offset possible shocks. This observation has important normative implications since it calls for keeping a somewhat tighter monetary stance when global conditions are supportive to lower the ELB in the future.

Finally, the models have rich implications for the use of alternative policy tools that can be de­ployed to overcome the ELB and restore monetary transmission. In particular, the presence of the ELB calls for an active use of the central bank's balance sheet, for example through quantitative easing and foreign exchange intervention. Furthermore, the ELB provides a new rationale for cap­ital controls and macro-prudential policies, as they can be successfully used to relax the tensions between domestic collateral constraints and capital flows. Fiscal policy can also help to overcome the ELB, while forward guidance is ineffective since the ELB increases with the expectation of looser future monetary conditions.

Looking ahead, the paper calls for more research along two fronts. First, it would be helpful to provide additional empirical evidence about the existence of the ELB. In principle, this would require showing that monetary easing is contractionary when domestic or international financial conditions are tight, for example as many argued during the Asian financial crisis. However, similar episodes are likely to be quite limited since, as described in the model, central banks do not have reasons to lower rates below the ELB when monetary easing becomes contractionary. It may thus be preferable to focus on how the ELB distorts the response of monetary policy to shocks in line with the suggestive evidence presented in the introduction. Second, future research can analyze the implications of the ELB using quantitative DSGE models. This would shed light on the exact circumstances under which the ELB may arise, on its level, and the extent to which monetary authorities should keep the economy below potential when the ELB is expected to bind in the near feature.


References

Acharya, Viral, Stephen Cecchetti, Jose De Gregorio, Sebnem Kalemli-Ozcan, Philip R. Lane, and Ugo Panizza. 2015. “Corporate Debt in Emerging Economies: A Threat to Financial Stabil­ity?” Committee on International Economic Policy and Reform.

Aghion, Philippe, Philippe Bacchetta, and Abhijit Banerjee. 2000. “A Simple Model of Mone­tary Policy and Currency Crises.” European Economic Review, 44(4-6): 728 - 738.

Aghion, Philippe, Philippe Bacchetta, and Abhijit Banerjee. 2001. “Currency Crises and Mon­etary Policy in an Economy with Credit Constraints.” European Economic Review, 45(7): 1121­1150.

Aoki, Kosuke, Gianluca Benigno, and Nobuhiro Kiyotaki. 2016. “Monetary and financial poli­cies in emerging markets.” Unpublished paper, London School of Economics.

Arregui, Nicolas, Selim Elekdag, Gaston Gelos, Romain Lafarguette, and Dulani Seneviratne.

2018. “Can Countries Manage Their Financial Conditions Amid Globalization?” IMF Working Paper No. 18/15.

Auclert, Adrien. 2016. “Monetary Policy and the Redistribution Channel.” Manuscript.

Avdjiev, Stefan, and Galina Hale. 2017. “U.S. monetary policy and fluctuations of international bank lending.” Manuscript.

Baskaya, Yusuf Soner, Julian di Giovanni, Sebnem Kalemli-Ozcan, and Mehmet Fatih Ulu.

2017. “International spillovers and local credit cycles.” NBER Working Paper No. 23149.

Benigno, Gianluca, Huigang Chen, Christopher Otrok, Alessandro Rebucci, and Eric R Young. 2013. “Financial crises and macro-prudential policies.” Journal of International Eco­nomics, 89(2): 453-470.

Benigno, Gianluca, Huigang Chen, Christopher Otrok, Alessandro Rebucci, and Eric R Young. 2016. “Optimal capital controls and real exchange rate policies: A pecuniary externality perspective.” Journal of Monetary Economics, 84: 147-165.

Bianchi, Javier. 2011. “Overborrowing and Systemic Externalities in the Business Cycle.” Ameri­can Economic Review, 101(7): 3400-3426.

Blanchard, Olivier, Jonathan D. Ostry, Atish R. Ghosh, and Marcos Chamon. 2016. “Capital Flows: Expansionary or Contractionary?” American Economic Review, 106(6): 565-69.

Brunnermeier, Markus K., and Yann Koby. 2016. “The “Reversal Interest Rate”: An Effective Lower Bound on Monetary Policy.” Manuscript.

Brunnermeier, Markus K, Stefan Nagel, and Lasse H Pedersen. 2008. “Carry trades and cur­rency crashes.” NBER macroeconomics annual, 23(1): 313-348.

Bruno, Valentina, and Hyun Song Shin. 2015. “Capital flows and the risk-taking channel of mon­etary policy.” Journal of Monetary Economics, 71: 119-132.

Bruno, Valentina, and Hyun Song Shin. 2017. “Global dollar credit and carry trades: a firm-level analysis.” The Review of Financial Studies, 30(3): 703-749.

Caballero, Julian, Ugo Panizza, and Andrew Powell. 2015. “The Second Wave of Global Liq­uidity: Why are Firms Acting like Financial Intermediaries?” CEPR Working Paper 10926.

Calvo, Guillermo A, and Carmen M Reinhart. 2002. “Fear of floating.” The Quarterly Journal of Economics, 117(2): 379-408.

Cavallino, Paolo. 2016. “Capital Flows and Foreign Exchange Intervention.” Unpublished Manuscript.

Cespedes, Luis Felipe, Roberto Chang, and Andres Velasco. 2004. “Balance Sheets and Ex­change Rate Policy.” The American Economic Review, 94(4): 1183-1193.

Christiano, Lawrence J., Christopher Gust, and Jorge Roldos. 2004. “Monetary Policy in a Financial Crisis.” Journal of Economic Theory, 119(1): 64-103.

Corte, Pasquale Della, Steven J Riddiough, and Lucio Sarno. 2016. “Currency premia and global imbalances.” The Review of Financial Studies, 29(8): 2161-2193.

Eggertsson, Gauti B., and Michael Woodford. 2003. “The Zero Bound on Interest Rates and Optimal Monetary Policy.” Brookings Papers on Economic Activity, 2003(1): 139-211.

Eggertsson, Gauti B., Ragnar E. Juelsrud, Lawrence H. Summers, and Ella Getz Wold. 2019. “Negative Nominal Interest Rates and the Bank Lending Channel.” NBER Working Paper No. 25416.

Farhi, Emmanuel, and Ivan Werning. 2016. “A Theory of Macroprudential Policies in the Pres­ence of Nominal Rigidities.” Econometrica, 84(5): 1645-1704.

Fornaro, Luca. 2015. “Financial crises and exchange rate policy.” Journal of International Eco­nomics, 95(2): 202-215.

Gabaix, Xavier, and Matteo Maggiori. 2015. “International Liquidity and Exchange Rate Dynam­ics.” Quarterly Journal of Economics, 130(3): 1369-1420.

Gertler, Mark, and Peter Karadi. 2011. “A model of unconventional monetary policy.” Journal of monetary Economics, 58(1): 17-34.

Gertler, Mark, Nobuhiro Kiyotaki, and Albert Queralto. 2012. “Financial crises, bank risk ex­posure and government financial policy.” Journal of Monetary Economics, 59: 17-34.

Gornemann, Nils, Keith Kuester, and Makoto Nakajima. 2016. “Doves for the Rich, Hawks for the Poor? Distributional Consequences of Monetary Policy.” International Finance Discussion Papers Number 1167.

Gourinchas, Pierre-Olivier. 2018. “Monetary Policy Transmission in Emerging Markets: An Ap­plication to Chile.” Central Banking, Analysis, and Economic Policies Book Series, 25: 279-324.

Guerrieri, Veronica, and Guido Lorenzoni. 2016. “Credit Crises, Precautionary Savings, and the Liquidity Trap.” Manuscript.

IMF. 2012. “The Liberalization and Management of Capital Flows - An Institutional View.” IMF Policy Paper.

Jeanne, Olivier, and Anton Korinek. 2010. “Excessive volatility in capital flows: A pigouvian taxation approach.” American Economic Review, 100(2): 403-07.

Kaplan, Greg, Benjamin Moll, and Gianluca L. Violante. 2016. “Monetary Policy According to HANK.” NBER Working Paper No. 21897.

Kollmann, Robert, Werner Roeger, and Jan in't Veld. 2012. “Fiscal Policy in a Financial Crisis: Standard Policy versus Bank Rescue Measures.” The American Economic Review, 102(3): 77-81.

Korinek, Anton, and Damiano Sandri. 2016. “Capital controls or macroprudential regulation?” Journal ofInternational Economics, 99: S27-S42.

Krugman, Paul. 1999. “Balance Sheets, the Transfer Problem, and Financial Crises.” In Interna­tional Finance and Financial Crises. , ed. Peter Isard, Assaf Razin and Andrew K. Rose, 31-55. Springer.

Krugman, Paul R., Kathryn M. Dominquez, and Kenneth Rogoff. 1998. “It’s baaack: Japan’s slump and the return of the liquidity trap.” Brookings Papers on Economic Activity, 1998(2): 137­205.

Lustig, Hanno, and Adrien Verdelhan. 2007. “The cross section of foreign currency risk premia and consumption growth risk.” American Economic Review, 97(1): 89-117.

Lustig, Hanno, Nikolai Roussanov, and Adrien Verdelhan. 2011. “Common risk factors in cur­rency markets.” The Review of Financial Studies, 24(11): 3731-3777.

McCauley, Robert N., Patrick McGuire, and Vladyslav Sushko. 2015. “Global Dollar Credit: Links to US Monetary Policy and Leverage.” Economic Policy, 30(82): 187-229.

McKay, Alisdair, Emi Nakamura, and Jon Steinsson. 2016. “The Power of Forward Guidance Revisited.” American Economic Review, 106(10): 3133-58.

Menkhoff, Lukas, Lucio Sarno, Maik Schmeling, and Andreas Schrimpf. 2012. “Carry trades and global foreign exchange volatility.” The Journal of Finance, 67(2): 681-718.

Negro, Marco Del, Gauti Eggertsson, Nubuhiro Kiyotaki, and Andrea Ferrero. 2011. “The Great Escape? A Quantitative Evaluation of the Fed’s Non-Standard Policies.” NY FED Staff Report no. 520.

Obstfeld, Maurice. 2015. “Trilemmas and Trade-offs: Living with Financial Globalization.” In Global Liquidity, Spillovers to Emerging Markets and Policy Responses. , ed. Claudio Raddatz, Diego Saravia and Jaume Ventura, Chapter 2, 13-78. Central Bank of Chile.

Ottonello, Pablo. 2015. “Optimal Exchange-Rate Policy Under Collateral Constraints and Wage Rigidities.” Manuscript.

Rajan, Raghuram. 2015. “Competitive Monetary Easing: Is it Yesterday once More?” Macroeco­nomics and Finance in Emerging Market Economies, 8(1-2): 5-16.

Rey, Helene. 2015. “Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence.” NBER Working Paper 21162.

Rey, Helene. 2016. “International Channels or Transmission of Monetary Policy and the Mundellian Trilemma.” IMF Economic Review, 64(1): 6-35.

Sandri, Damiano, and Fabian Valencia. 2013. “Financial Crises and Recapitalizations.” Journal of Money, Credit and Banking, 45(s2): 59-86.

Svensson, Lars E.O. 2003. “Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others.” Journal of Economic Perspectives, 17(4): 145-166.

Werning, Ivan. 2015. “Incomplete Markets and Aggregate Demand.” NBER Working Paper 21448.

Wu, Jing Cynthia, and Fan Dora Xia. 2016. “Measuring the macroeconomic impact of monetary policy at the zero lower bound.” Journal of Money, Credit and Banking, 48(2-3): 253-291.

Image yik8

Image yjvi

Image gqtm

Image im8r

Image ayei

Image oobf

Image d1p

Image 3cxd

Image eidv

Image 8ymo

Image seqe