The Effect of Capital Controls on Interest Rate Differentials
AbstractIn this paper we present a model of international interest rate arbitrage under conditions of entry and exit costs to and from the domestic capital market. We seek to measure the maximum potential effect of capital controls, such as non-interest paying reserve requirements, on interest rate differentials. We quantify the effect of such taxes using a dynamic optimization model with uncertainty and transaction costs. An optimal (S,s) rule gives the limits for interest rate differentials that trigger massive capital inflows and outflows. We also calculate maximum sustainable interest rate differentials for various maturities and study the effect of parameter changes. Using parameters estimated for the Chilean economy, the model shows that the effect of capital controls on interest rate differentials is considerably smaller than what static calculations suggest.
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Bibliographic InfoPaper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 50.
Date of creation: Nov 1999
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