The first option for responding to capital flow volatility may be to use the exchange rate as an automatic stabilizer under a freely-floating regime. Allowing the rate to move freely at all times can prevent excessive inflows by dampening appreciation expectations. But the real economy may be unable to adapt to large exchange rate swings within a short period and may be negatively affected.
A country may intervene to limit exchange rate volatility or to slow the currency’s appreciation. But siphoning off the liquidity injected through sterilization may damage the central bank’s balance sheet and attract further inflows by maintaining a gap between domestic and international interest rates. As a last resort, capital controls may also be considered as a few countries have introduced recently.