Monetary and Macroprudential Policies Under Dollar-Denominated Foreign Debt

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 where an interaction between currency mismatch in a borrowing constraint and balance of payments adjustments amplifies currency depreciation during a crisis and causes severe economic downturns. Because private agents take the exchange rate as given, they borrow too much in normal times and import too much during a crisis. The optimal discretionary monetary policy leans against the wind to correct ex ante overborrowing. The optimal policy mix is to impose an ex ante macroprudential tax to correct overborrowing and ex post contractionary monetary policy interventions to mitigate currency depreciation