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Dealing with the Trilemma: Optimal Capital Controls with Fixed Exchange Rates

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  • Emmanuel Farhi
  • Ivan Werning

Abstract

We lay down a standard macroeconomic model of a small open economy with a fixed exchange rate and study optimal capital controls (defined as maximizing the utility of a representative household). We provide sharp analytical and numerical characterizations for a variety of shocks. We find that capital controls are employed to respond to some shocks but not others. They are particularly effective to address risk-premium shocks that affect the interest rate differential foreign investors require in a particular country. We also discuss how the solution depends on the degree of nominal rigidity and the openness of the economy. We show that capital controls may be optimal even if the exchange rate is not fixed in response to risk premium shocks or if wages, in addition to prices, are sticky. Finally, we compare the single country’s optimum to a coordinated world solution. Our results show a limited need for coordination. However, the uncoordinated solution features the same capital controls as the coordinated solution.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 18199.

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Date of creation: Jun 2012
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Handle: RePEc:nbr:nberwo:18199

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References

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  1. Pablo A. Neumeyer & Fabrizio Perri, 2004. "Business Cycles in Emerging Economies: The Role of Interest Rates," NBER Working Papers 10387, National Bureau of Economic Research, Inc.
  2. Alberto Martin & Filippo Taddei, 2012. "International Capital Flows and Credit Market Imperfections: a Tale of Two Frictions," Working Papers 518, Barcelona Graduate School of Economics.
  3. Arnaud Costinot & Guido Lorenzoni & Iván Werning, 2011. "A Theory of Capital Controls as Dynamic Terms-of-Trade Manipulation," NBER Working Papers 17680, National Bureau of Economic Research, Inc.
  4. Jordi Gal� & Tommaso Monacelli, 2005. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Review of Economic Studies, Oxford University Press, vol. 72(3), pages 707-734.
  5. Richard Clarida & Jordi Gali & Mark Gertler, 2002. "A Simple Framework for International Monetary Policy Analysis," NBER Working Papers 8870, National Bureau of Economic Research, Inc.
  6. Guillermo A. Calvo, 1998. "Capital Flows and Capital-Market Crises: The Simple Economics of Sudden Stops," Journal of Applied Economics, Universidad del CEMA, vol. 0, pages 35-54, November.
  7. Stanley W. Black, 1972. "International money markets and flexible exchange rates," Staff Studies 70, Board of Governors of the Federal Reserve System (U.S.).
  8. Maurice Obstfeld and Kenneth Rogoff., 1995. "Exchange Rate Dynamics Redux," Center for International and Development Economics Research (CIDER) Working Papers C95-048, University of California at Berkeley.
  9. Jonathan David Ostry & Atish R. Ghosh & Karl Friedrich Habermeier & Marcos Chamon & Mahvash Saeed Qureshi & Dennis B. S. Reinhardt, 2010. "Capital Inflows," IMF Staff Position Notes 2010/04, International Monetary Fund.
  10. Ricardo Caballero & Arvind Krishnamurthy, 2000. "International and Domestic Collateral Constraints in a Model of Emerging Market Crises," NBER Working Papers 7971, National Bureau of Economic Research, Inc.
  11. Anton Korinek, 2011. "The New Economics of Prudential Capital Controls: A Research Agenda," IMF Economic Review, Palgrave Macmillan, vol. 59(3), pages 523-561, August.
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Cited by:
  1. Yan Carriere-Swallow & Pablo Garcia-Silva, 2013. "Capital Account Policies in Chile Macro-financial considerations along the path to liberalization," IMF Working Papers 13/107, International Monetary Fund.
  2. Alp Simsek & Anton Korinek, 2013. "Liquidity Trap and Excessive Leverage," 2013 Meeting Papers 1369, Society for Economic Dynamics.
  3. Zheng Liu & Mark M. Spiegel, 2013. "Monetary policy regimes and capital account restrictions in a small open economy," Working Paper Series 2013-33, Federal Reserve Bank of San Francisco.
  4. Agnès Bénassy-Quéré & Benjamin Carton & Ludovic Gauvin, 2011. "Rebalancing Growth in China: An International Perspective," Working Papers 2011-08, CEPII research center.
  5. Javier Bianchi & Enrique G. Mendoza, 2013. "Optimal Time-Consistent Macroprudential Policy," NBER Working Papers 19704, National Bureau of Economic Research, Inc.
  6. Javier Bianchi, 2012. "Comment on "Capital Account Policies and the Real Exchange Rate"," NBER Chapters, in: NBER International Seminar on Macroeconomics 2012, pages 43-48 National Bureau of Economic Research, Inc.
  7. Michael W. Klein & Jay C. Shambaugh, 2013. "Rounding the Corners of the Policy Trilemma: Sources of Monetary Policy Autonomy," NBER Working Papers 19461, National Bureau of Economic Research, Inc.
  8. Jeanne, Olivier, 2013. "Macroprudential policies in a global perspective," Proceedings, Federal Reserve Bank of San Francisco, issue Nov, pages 1-38.
  9. Kris James Mitchener & Kirsten Wandschneider, 2014. "Capital Controls and Recovery from the Financial Crisis of the 1930s," NBER Working Papers 20220, National Bureau of Economic Research, Inc.
  10. Andrés Fernández & Alessandro Rebucci & Martín Uribe, 2013. "Are Capital Controls Prudential? An Empirical Investigation," NBER Working Papers 19671, National Bureau of Economic Research, Inc.
  11. Chun Chang & Zheng Liu & Mark M. Spiegel, 2013. "Capital controls and optimal Chinese monetary policy," Working Paper Series 2012-13, Federal Reserve Bank of San Francisco.
  12. Michael B. Devereux & James Yetman, 2014. "Capital Controls, Global Liquidity Traps, and the International Policy Trilemma," Scandinavian Journal of Economics, Wiley Blackwell, vol. 116(1), pages 158-189, 01.
  13. Timothy J. Kehoe & Kim J. Ruhl & Joseph B. Steinberg, 2013. "What will happen when foreigners stop lending to the United States?," Economic Policy Paper 13-4, Federal Reserve Bank of Minneapolis.
  14. Kai Liu, 2014. "Dollar Hegemony and China’s Economy," Cambridge Working Papers in Economics 1410, Faculty of Economics, University of Cambridge.
  15. D. Filiz Unsal, 2013. "Capital Flows and Financial Stability: Monetary Policy and Macroprudential Responses," International Journal of Central Banking, International Journal of Central Banking, vol. 9(1), pages 233-285, March.

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