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This paper studies the implications of using the volatility of domestic interest rate as a policy instrument in an open economy. We develop a two-region macroeconomic model in which short- term capital flows are carefully distinguished from Foreign Direct Investment (FDI). We focus on the effectiveness of using domestic interest rate volatility as a policy tool to affect the com- position of capital inflows between short-term securities and FDI, and we identify the trade-o↵s that are faced in navigating external balance and price stability. We find that three channels of uncertainty transmission arise in affecting the composition of external account. First, a precau- tionary savings channel discourages short-term debt and contributes to an outflow. Second, a precautionary pricing channel contributes to an upward-bias in price setting and diminishes the return from FDI, causing net FDI outflows. Finally, introducing time-to-build to FDI damp- ens net FDI outflows due to irreversibility implied by time-to-build (growth options channel). Currency of export invoicing and risk aversion of outside agents are important determinants in generating these results. Furthermore, we conclude that under every scenario, an increase in policy uncertainty is inflationary. Our analysis is both normative and positive.
