This paper studies both positive and normative aspects of quantity-based capital controls in a small open economy undergoing a temporary inflation stabilization plan. In the model, capital controls are implemented by choosing two policy variables: a ceiling on the private sector debt and a terminal date for removing controls; the date on which controls trigger and hence its duration are endogenously determined. Equilibrium dynamics are characterized for all feasible range of debt ceilings and durations. Temporary controls that end with the collapse of the stabilization plan are shown to mitigate consumption boom-bust cycles and dominate allocations under perfect capital mobility, thus providing a "second-best" rationale for employing them. For controls that are prolonged beyond the collapse of the stabilization plan, equilibria exist even when the debt ceiling is above the debt that accumulates under perfect capital mobility. Here, if the ceiling is sufficiently low, controls mitigate consumption cycles. Conversely, a sufficiently high ceiling amplifies consumption cycles. For prolonged controls, there is a critical value of debt ceiling below (above) which the welfare is higher (lower) relative to the perfect capital mobility case. Finally, for a given debt ceiling, prolonged controls rank lower in welfare than those that end with the stabilization plan.
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Paper provided by Iowa State University, Department of Economics in its series Staff General Research Papers with number
12682.
Length: Date of creation: 21 Sep 2006 Date of revision: Publication status: Published in Economic Theory, March 2008, Vol. 34, No. 3, pp. 545-574. Handle: RePEc:isu:genres:12682
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Find related papers by JEL classification: F3 - International Economics - - International Finance F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance
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