Capital controls: a normative analysis

Countries' concerns with the value of their currency have been extensively studied and documented in the literature. Capital controls can be (and often are) used as a tool to manage exchange rate fluctuations. This paper investigates whether countries can benefi t from using such a tool. We develop a welfare based analysis of whether (or, in fact, how)countries should tax international borrowing. Our results suggest that managing exchange rate movements with the use of these taxes can be benefi cial for individual countries although it would limit cross-border pooling of risk. This is because while consumption risk-pooling is important, individual countries also care about domestic output fluctuations. Moreover, the results show that countries decide to restrict the international flow of capital exactly when this flow is crucial to ensure cross-border risk-sharing. Our findings thus point to important gains from international coordination in the use of capital controls.