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We investigate the role of macroprudential policies in mitigating liquidity traps. When constrained households engage in deleveraging, the interest rate needs to fall to induce unconstrained households to pick up the decline in aggregate demand. If the fall in the interest rate is limited by the zero lower bound, aggregate demand is insufficient and the economy enters a liquidity trap. In this environment, households' ex ante leverage and insurance decisions are associated with aggregate demand externalities. Welfare can be improved with macroprudential policies targeted toward reducing leverage. Interest rate policy is inferior to macroprudential policies in dealing with excessive leverage.

This paper provides an introduction to the new economics of prudential capital controls in emerging economies. This literature is based on the notion that there are externalities associated with financial crises because individual market participants do not internalize their contribution to aggregate financial instability. We describe financial crises as situations in which an emerging economy loses access to international financial markets and experiences a feedback loop in which declining aggregate demand, falling exchange rates and asset prices, and deteriorating balance sheets mutually reinforce each other — a common phenomenon in recent emerging market crises. Individual market participants take aggregate prices and financial conditions as given and do not internalize their contribution to financial instability when they choose their actions. As a result they impose externalities in the form of greater financial instability on each other, and the private financing decisions of individuals are distorted toward excessive risk-taking. Prudential capital controls can induce private agents to internalize their externalities and thereby increase macroeconomic stability and enhance welfare.

This paper presents a welfare case for prudential controls on capital flows to emerging markets as a form of Pigouvian taxation that aims to reduce the externalities associated with the deleveraging cycle. We argue that restricting capital inflows during boom times reduces the potential outflows during busts. This mitigates the feedback cycle during such deleveraging episodes, when tightening financial constraints on borrowers and collapsing prices of collateral assets mutually reinforce each other. As a result, macroeconomic volatility is smoothed and welfare is unambiguously increased. This paper presents a simple model of collateralized international borrowing, in which the value of collateral assets endogenously depends on the state of the economy. When financial constraints are binding in such a setup, financial amplification effects (sudden stops) arise as declining collateral values, tightening financial constraints and falling consumption mutually reinforce each other. Such amplification effects are not internalized by individual borrowers and constitute a negative externality that provides a natural rational for the Pigouvian taxation of international borrowing.

In the 1990s, Sudden Stops in emerging markets were a harbinger of the 2008 global financial crisis. During these Sudden Stops, countries lost access to credit, which caused abrupt current account reversals, and suffered severe recessions. This article reviews a class of models that yield quantitative predictions consistent with these observations, based on an occasionally binding credit constraint that limits debt to a fraction of the market value of incomes or assets used as collateral. Sudden Stops are infrequent events nested within regular business cycles and occur in response to standard shocks after periods of expansion increase leverage ratios sufficiently. When this happens, the Fisherian debt-deflation mechanism is set in motion, as lower asset or goods prices tighten the constraint further, causing further deflation. This framework also embodies a pecuniary externality with important implications for macroprudential policy because agents do not internalize how current borrowing decisions affect collateral values during future financial crises.

This article characterizes the efficiency properties of competitive economies with financial constraints, in which phenomena such as fire sales and financial amplification may arise. We show that financial constraints lead to two distinct types of pecuniary externalities: distributive externalities that arise from incomplete insurance markets and collateral externalities that arise from price-dependent financial constraints. For both types of externalities, we identify three sufficient statistics that determine optimal taxes on financing and investment decisions to implement constrained efficient allocations. We also show that fire sales and financial amplification are neither necessary nor sufficient to generate inefficient pecuniary externalities. We demonstrate how to employ our framework in a number of applications. Whereas collateral externalities generally lead to over-borrowing, the distortions from distributive externalities may easily flip sign, leading to either under- or over-borrowing. Both types of externalities may lead to under- or over-investment.

How should macroprudential policy be designed when policymakers also have access to liquidity provision tools to manage crises? We show in a tractable model of systemic banking risk that there are three factors at play: first, ex post liquidity provision mitigates financial crises, and this reduces the need for macroprudential policy. In the extreme, if liquidity provision is untargeted and costless or if it completely forestalls crises by credible out-of-equilibrium lending-of-last-resort, there is no role left for macroprudential regulation. Second, however, macroprudential policy needs to consider the ex ante incentive effects of targeted liquidity provision. Third, if shadow banking reduces the effectiveness of macroprudential instruments, it is optimal to commit to less generous liquidity provision as a second-best substitute for macroprudential policy.

This paper synthesizes recent advances in the theoretical and empirical literature on capital controls. We start by observing that international capital flows have both benefits and costs, but some of these are not internalized by individual actors and thus constitute externalities. The theoretical literature has identified pecuniary externalities and aggregate demand externalities that respectively contribute to financial instability and recessions. These externalities provide a natural rationale for countercyclical capital controls that lean against boom and bust cycles in international capital flows. The empirical literature has developed several measures of capital controls to capture different aspects of capital account openness. We evaluate the strengths and weaknesses of different measures and provide an overview of the empirical findings on the effectiveness of capital controls in addressing the externalities identified by the theory literature, that is, in reducing financial fragility and enhancing macroeconomic stability. We also discuss strategies to deal with the endogeneity of capital controls in such statistical exercises. We conclude by providing an overview of the historical and current debates on the role of capital controls in macroeconomic management and their relationship to the academic literature.

We analyze recent theoretical advances in the area of capital flow management and compare them with the IMF’s policy frameworks in the area, as laid out in the IMF’s Institutional View and related documents. Although the Institutional View represented an important leap forward, we discuss several tensions with the academic literature. We also emphasize the important role that the IMF guidance could play in building a better set of policy instruments to deal with volatile capital flows. More broadly, individual countries need sufficient policy space to pursue their individual welfare objectives. Finally, we propose how to strengthen the IMF’s analytical framework for international spillovers.

Anton Korinek and Joseph E Stiglitz make the case for a deliberate effort to steer technological advances in a direction that enhances the role of human workers

As artificial-intelligence (AI) systems become more capable, their potential labor-market effects may aggravate inequality and by extension undermine democratic governance. Moreover, the interrelationship between democracy and inequality may trigger a feedback loop, whereby increases in inequality undermine democracy, which in turn lead to policies that further increase inequality, giving rise to multiplier effects. In the short term, policies to mitigate AI-induced inequality include steering the direction of advances in AI to enhance human-AI collaboration, strengthening worker power and agency, and adjusting tax codes to not incentivize automating human labor. In the longer term, these policies include distributing the surplus generated by AI and taking measures against the adverse effects of market concentration in the AI industry. Moreover, policies that protect and strengthen democratic processes may lead to virtuous multiplier effects by reducing inequality. We hope that with thoughtful governance societies can harness AI's benefits while ensuring broadly shared prosperity. However, policymakers must act swiftly given AI's rapid development.