Unintended Consequences of U.S. Monetary Policy Shocks: Dutch Disease and Capital Flow Measures in Emerging Markets and Developing Economies∗

Abstract

Dutch disease is often referred to as a situation in which large and sustained foreign-currency inflows lead to a contraction of the tradable sector by giving rise to a real appreciation of the home currency. This paper documents that this syn-drome has been witnessed by several emerging markets and developing economies (EMDEs) as a result of sharp surges in capital inflows driven by accommodative U.S. monetary policy after the global financial crisis. In a sample of 25 EMDEs from 2000 to 2017, the loosening of U.S. monetary policy usu-ally coincided with episodes of significant currency appreciation and a contraction in tradable output in these economies. The paper also shows empirically that the use of capital flow measures (CFMs) has been a common policy response in several EMDEs, and CFMs are somewhat effective in insulating these economies from U.S. monetary policy shocks. The paper also presents a two-sector small open economy augmented with a learning-by-doing (LBD) mechanism in the tradable sector to rationalize these empirical findings. A welfare analysis pro-vides a rationale for the use of CFMs as a second-best policy when agents do not internalize the LBD externality of costly resource misallocation. However, the adequate calibration of CFMs and the accurate quantification of the LBD externality represent important implementation challenges.