Abstract:

Emerging economies use international capital markets to finance investment and consumption expenditures. The capital flows to these economies, however, are highly volatile. In particular, episodes in which capital inflows suddenly turn into capital outflows, commonly known as 'sudden stops', are recurrent events. Some argue, appealing to the traditional Keynesian transmission mechanism, that a loose monetary policy is required to boost output, making the crisis less severe.

In this dissertation I use the primal approach to optimal taxation to jointly study the optimal fiscal and monetary policy response to sudden stops, in an environment that captures the traditional Keynesian mechanism of price rigidities. Under the optimal policy, labor income taxes should decline when a sudden stop hits the economy. Optimal capital income taxes could increase or decrease depending on parameter values. With respect to monetary policy, a sudden stop requires a contraction in the money supply, an increase in the nominal interest rate, and a nominal depreciation. In addition, I discuss the role of self-insurance in the management and prevention of crises.