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Capital Controls or Exchange Rate Policy? A Pecuniary Externality Perspective

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  • Gianluca Benigno
  • Huigang Chen
  • Christopher Otrok
  • Alessandro Rebucci
  • Eric R. Young

Abstract

In the aftermath of the global financial crisis, a new policy paradigm has emerged in which old-fashioned policies such as capital controls and other government distortions have become part of the standard policy toolkit (the so-called macro-prudential policies). On the wave of this seemingly unanimous policy consensus, a new strand of theoretical literature contends that capital controls are welfare enhancing and can be justified rigorously because of second-best considerations. Within the same theoretical framework adopted in this fast-growing literature, we show that a credible commitment to support the exchange rate in crisis times always welfare-dominates prudential capital controls as it can achieve the first best unconstrained allocation. In this benchmark economy, prudential capital controls are optimal only when the set of policy tools is restricted so that they are the only policy instrument available.

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Bibliographic Info

Paper provided by Centre for Economic Performance, LSE in its series CEP Discussion Papers with number dp1160.

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Date of creation: Aug 2012
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Handle: RePEc:cep:cepdps:dp1160

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Web page: http://cep.lse.ac.uk/_new/publications/series.asp?prog=CEP

Related research

Keywords: Capital controls; exchange rate policy; financial frictions; financial crises; financial stability; optimal taxation; prudential policies; planning problem;

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References

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  1. Gianluca Benigno & Huigang Chen & Christopher Otrok & Alessandro Rebucci & Eric R. Young, 2010. "Revisiting Overborrowing and its Policy Implications," Working Papers Central Bank of Chile, Central Bank of Chile 582, Central Bank of Chile.
  2. Gianluca Benigno & Huigang Chen & Christopher Otrok & Alessandro Rebucci & Eric R. Young, 2011. "Financial Crises and Macro-Prudential Policies," IDB Publications 27738, Inter-American Development Bank.
  3. Arnaud Costinot & Guido Lorenzoni & Iv�n Werning, 2014. "A Theory of Capital Controls as Dynamic Terms-of-Trade Manipulation," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 122(1), pages 77 - 128.
  4. Javier Bianchi, 2009. "Overborrowing and systemic externalities in the business cycle," Working Paper, Federal Reserve Bank of Atlanta 2009-24, Federal Reserve Bank of Atlanta.
  5. Timothy J Kehoe & David K Levine, 1993. "Debt Constrained Asset Markets," Levine's Working Paper Archive 1276, David K. Levine.
  6. Nicolas E. Magud & Carmen M. Reinhart & Kenneth S. Rogoff, 2011. "Capital Controls: Myth and Reality - A Portfolio Balance Approach," NBER Working Papers 16805, National Bureau of Economic Research, Inc.
  7. Bruce Ian Carlin & Shaun William Davies & Andrew Miles Iannaccone, 2010. "Competing for Attention in Financial Markets," NBER Working Papers 16085, National Bureau of Economic Research, Inc.
  8. Luis Felipe Céspedes & Roberto Chang & Diego Saravia, 2010. "Monetary Policy Under Financial Turbulence: an Overview," Working Papers Central Bank of Chile, Central Bank of Chile 594, Central Bank of Chile.
  9. Enrique Mendoza & Javier Bianchi, 2010. "Overborrowing, financial crises and ‘macro-prudential’ taxes," Proceedings, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco, issue Oct.
  10. De Paoli, Bianca & Lipinska, Anna, 2012. "Capital controls: a normative analysis," Proceedings, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco, issue Nov, pages 1-36.
  11. Paul Krugman, 1999. "Balance Sheets, the Transfer Problem, and Financial Crises," International Tax and Public Finance, Springer, Springer, vol. 6(4), pages 459-472, November.
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Cited by:
  1. Mitsuru Katagiri & Ryo Kato & Takayuki Tsuruga, 2013. "Prudential Capital Controls: The Impact of Different Collateral Constraint Assumptions," Discussion papers e-12-014, Graduate School of Economics Project Center, Kyoto University.
  2. Gianluca Benigno & Huigang Chen & Chris Otrok & Alessandro Rebucci & Eric Young, 2012. "Optimal policy for macro-financial stability," LSE Research Online Documents on Economics, London School of Economics and Political Science, LSE Library 51519, London School of Economics and Political Science, LSE Library.
  3. Gianluca Benigno & Luca Fornaro, 2013. "The Financial Resource Curse," CEP Discussion Papers dp1217, Centre for Economic Performance, LSE.
  4. Gianluca Benigno & Huigang Chen & Christopher Otrok & Alessandro Rebucci & Eric Young, 2011. "Financial Crises and Macro-Prudential Policies," Research Department Publications, Inter-American Development Bank, Research Department 4710, Inter-American Development Bank, Research Department.
  5. Timothy J. Kehoe & Kim J. Ruhl & Joseph B. Steinberg, 2013. "What will happen when foreigners stop lending to the United States?," Economic Policy Paper, Federal Reserve Bank of Minneapolis 13-4, Federal Reserve Bank of Minneapolis.

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