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The Effect of Capital Controls on Interest Rate Differentials

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  • Herrera, L.O.
  • Valdes, R.
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    Abstract

    In 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 Info

    Paper provided by Cambridge - Risk, Information & Quantity Signals in its series Papers with number 50.

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    Length: 27 pages
    Date of creation: 1999
    Date of revision:
    Handle: RePEc:fth:cambri:50

    Contact details of provider:
    Postal: UNIVERSITY OF CAMBRIDGE, RESEARCH PROJECT ON RISK, INFORMATION AND QUANTITY SIGNALS IN ECONOMICS(E.S.R.C.), DEPARTMENT OF APPLIED ECONOMICS, SIDGWICK AV. CAMBRIDGE CB3 9DEDE U.K..
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    Web page: http://www.econ.cam.ac.uk/
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    Keywords: INTEREST RATE ; FINANCIAL MARKET;

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    Cited by:
    1. Herrera, Luis Oscar & Valdes, Rodrigo O., 2001. "The effect of capital controls on interest rate differentials," Journal of International Economics, Elsevier, vol. 53(2), pages 385-398, April.

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