Global Financial Cycle and Liquidity Management
We use a tractable model to show that emerging markets can protect themselves from the global financial cycle by expanding (rather than restricting) capital flows. This involves accumulating reserves when global liquidity is high to buy back domestic assets at a discount when global financial conditions tighten. Since the private sector does not internalize how this buffering mechanism reduces international borrowing costs, a social planner increases the size of capital flows beyond the laissez-faire equilibrium. The model also provides a role for foreign exchange intervention in less financially developed countries. The main predictions of the model are consistent with the data.
This paper benefitted from comments from seminar participants in the 2017 IMF Annual Research Conference, the London Business School, the 2020 AEA Annual Meetings, and the World Bank. We thank our discussants Gianluca Benigno and Kinda Hachem for their comments. The views expressed herein are those of the authors and do not necessarily reflect the views of the IMF, its Executive Board, IMF management, or the National Bureau of Economic Research.