Capital controls and foreign exchange market intervention

High level of capital controls and volatile exchange rates in developing countries are considered suboptimal in classical trilemma frameworks. The paper presents a New Keynesian small open economy model that assesses middle-ground policies, such as partial capital controls and managed exchange regimes. The paper introduces a policy-endogenous risk premium, which creates financial frictions; breaking exchange rate peg exposes foreign investors to exchange rate risk and even signals the country’s economic instability, and financial sector responds by raising the country’s exchange rate risk premium. Contrary to the classical theory, the results suggest that implementing both capital controls and managed exchange regimes can be optimal, while maintaining domestic monetary policy sovereignty.