Macroprudential Regulation of International Finance

Macroprudential Regulation of International Finance

Managing Capital Flows and Exchange Rates

KDI/EWC series on Economic Policy

Edited by Dongsoo Kang and Andrew Mason

Recent events, such as capital flow reversals and banking sector crises, have shaken faith in the widely held belief in the benefits of greater financial integration and financial deepening, which are typical in advanced economies. This book shows that emerging economies have often weathered the storm best despite the supposed burden of ‘weak institutions’. It demonstrates that a better policy framework requires reliable indicators of vulnerability to financial instability, as well as improved policy tools and automatic stabilizers that anticipate and limit the vulnerabilities to financial crises.

Chapter 1: Introduction and overview

Dongsoo Kang and Andrew Mason

Subjects: asian studies, asian economics, economics and finance, asian economics, financial economics and regulation


Floating exchange rates and free cross-border mobility of financial claims allow an economy to adjust to external macroeconomic shocks. Milton Friedman’s essay on the case for flexible exchange rates (Friedman, 1953) is a classic statement of the role of floating exchange rates in allowing an economy to adjust its real prices and wages in the face of shocks to its fundamentals. In the same spirit, the flexible exchange rate version of the Mundell-Fleming model (Fleming, 1962; Mundell, 1963) lays out the case for how flexible exchange rates allow monetary authorities to pursue domestic macroeconomic objectives in a world of free capital flows. Financial integration allows resources to flow from capital-rich economies to capital-poor economies, and these financial resources augment domestic funds in financing investment. Post-crisis discussions of capital flows and monetary policy spillovers have revisited these classic propositions. The procyclicality of the financial system has been at the center of these discussions. Although the procyclicality of the financial system could manifest itself in a purely domestic context, the cross-border dimension is often important, both for advanced and emerging economies. Cross-border capital flows driven by the leverage cycle of banks and other financial intermediaries figured prominently during the 2008–09 global financial crisis. For observers of emerging market crises of the 1990s, the lessons learned from the more recent episodes of financial turbulence provided an opportunity to revisit some of the timeworn lessons.