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Is It Time to Get Radical? A Game Theoritic analysis of Asian Crisis and Capital Control

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  • Martawardaya, Berly
  • Salotti, Simone

Abstract

Policymakers in modern and open economies face a macroeconomic trilemma (Obstfeld, Shambaugh, and Taylor 2005). There are three main sought-after objectives: 1. to stabilize the exchange rate; 2. to enjoy free international capital mobility 3. to engage in a monetary policy oriented toward domestic goals. Three main questions that we try to answer are : How the crisis exacerbated by international investor racing to pull out their capital from affected coutnries? Can capital control reduce it? Can capital control reduce contagion effect and regional financial instability? Using game theoritical framework and insight from behavioral economics, we analyzed herd behaviour of international investors in the time of financial crisis. Under free international capital mobility, uncertainty and lack of coordination among investors with short-horizon, we found prisoner dilemma type of arrangement that exacerbated financial crisis. Applying the anylisis to multi-stage game with government, we found that a credible threat of capital control could reduce herd behaviour and escape the worst of financial crisis. Therefore, fredom to employ capital control is a policy tool that enable escape from the trilemma and pursue all three goals at the same time. We modify the framework to include multiple countries under financial crisis and fear of contagion. We found the ability to impose capital control, under certain conditions, will isolate the crisis and reduce contagion effect. We also explore the critical value when capital control should be enacted with regard to domestic economic condition, on which government political mandate base upon, and differences of reactions in relation to political regime. We conclude by citing incidences of insistance toward comitment against capital control by IMF in loans approcal and US in free trade agreement as misdirected, unncessesary and even harmful in some cases.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 2073.

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Date of creation: 24 Nov 2006
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Handle: RePEc:pra:mprapa:2073

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Keywords: Asiena crisis; game theory; capital control;

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  1. Maurice Obstfeld & Jay C. Shambaugh & Alan M. Taylor, 2004. "The Trilemma in History: Tradeoffs among Exchange Rates, Monetary Policies, and Capital Mobility," NBER Working Papers 10396, National Bureau of Economic Research, Inc.
  2. Kenneth Rogoff, 1999. "International Institutions for Reducing Global Financial Instability," Journal of Economic Perspectives, American Economic Association, American Economic Association, vol. 13(4), pages 21-42, Fall.
  3. Paul Masson, 1999. "Multiple equilibria, contagion, and the emerging market crises," Proceedings, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco, issue Sep.
  4. Steven Radelet & Jeffrey Sachs, 1998. "The Onset of the East Asian Financial Crisis," NBER Working Papers 6680, National Bureau of Economic Research, Inc.
  5. Nicolas Magud & Carmen M. Reinhart, 2005. "Capital Controls: An Evaluation," University of Oregon Economics Department Working Papers, University of Oregon Economics Department 2005-19, University of Oregon Economics Department.
    • Nicolas Magud & Carmen M. Reinhart, 2007. "Capital Controls: An Evaluation," NBER Chapters, in: Capital Controls and Capital Flows in Emerging Economies: Policies, Practices and Consequences, pages 645-674 National Bureau of Economic Research, Inc.
  6. Jason Furman & Joseph E. Stiglitz, 1998. "Economic Crises: Evidence and Insights from East Asia," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(2), pages 1-136.
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