Optimal IMF Policy with Private Capital Flows

This paper characterizes optimal IMF policy in an environment with moral hazard followed by adverse selection. In our framework, government actions to improve domestic productivity are not always e¤ective, and the government learns of the success of its actions before foreign investors. Without the IMF, it is not possible for foreign investors to discern the quality of the domestic production sector. There only exists a pooling equilibrium ex post, which leads to low government e¤ort ex ante. Optimal IMF intervention is the solution to a mechanism design problem in the presence of imperfectly informed competitive markets. Optimal IMF policy is structured so as to reveal the government’s private information to foreign investors in a separating equilibrium. Government e¤ort ex ante is high. Countries with weak fundamentals ex post accept IMF transfers and face high interest rates on private capital markets. Countries with strong fundamentals make contributions to the IMF and receive low interest rates from foreign investors.