This paper studies the optimal monetary and macroprudential policies in a small open economy that borrows from abroad in foreign currency. The model features a novel mechanism in which sudden stops due to an occasionally binding borrowing constraint trigger a sharp currency depreciation through balance of payments adjustments, thereby increase the domestic-currency value of foreign debt and cause severe economic downturns. A policy analysis shows that a contractionary monetary policy mitigates depreciation during a crisis, but the anticipation of policy interventions during the crisis induces larger borrowings ex ante and destabilizes the economy. A combination of an ex ante macroprudential tax on foreign borrowing and ex post monetary policy interventions can stabilize the economy and improve social welfare.
Keywords: Exchange rate; Balance of payments; Sudden stops; Monetary policy; Macroprudential policy
Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.