Capital Controls and Welfare with Cross-Border Bank Capital Flows

This paper studies the performance of time-varying capital controls on cross-border bank borrowing in an open-economy, dynamic stochastic general equilibrium model with credit market frictions and imperfect capital mobility. The model is calibrated for a middle-income country and is shown to replicate the main stylized facts associated with a fall in world interest rates (capital inflows, real appreciation, credit boom, asset price pressures, and output expansion). A capital controls rule, which is fundamentally macroprudential in nature, is defined in terms of either changes in bank foreign borrowing or cyclical output. An optimal, welfare-maximizing rule is established numerically. The analysis is then extended to solve jointly for optimal countercyclical reserve requirements and capital controls rules. These instruments are complements in the sense that both are needed to maximize welfare. However, a more aggressive reserve requirement rule (which responds to the credit-output ratio) also induces less reliance on capital controls. Thus, at the margin, countercyclical reserve requirements and capital controls are partial substitutes in maximizing welfare.