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Working Paper
Managing Capital Flows in the Presence of External Risks
We introduce external risks, in the form of shocks to the level and volatility of world interest rates, into a small open economy model subject to the risk of sudden stops?large recessions together with abrupt reversals in capital inflows| and characterize optimal macroprudential policy in response to these shocks. In the model, collateral constraints create a pecuniary externality that leads to "overborrowing" and sudden stops that arise when the constraints bind. The typical sudden stop generated by the model replicates existing empirical evidence for emerging market economies: Low and ...