Capital Controls or Macroprudential Regulation?

International capital flows can create significant financial instability in emerging economies. Does this make it optimal to impose capital controls or should policymakers rely on domestic macroprudential regulation in their quest for greater financial stability? This paper shows that it is desirable to employ both instruments to mitigate contractionary exchange rate depreciations: Macroprudential regulation reduces the amount and riskiness of financial liabilities, no matter whether they are financed by domestic or foreign lenders; capital controls increase the aggregate net worth of the economy by reducing net inflows. Both types of policy measures make the economy more stable and reduce the incidence and severity of crises. They should be set higher the greater an economy's debt burden and the higher domestic inequality. In a calibration based on the East Asian crisis countries, we find that it is optimal to impose both capital controls and macroprudential regulation that amount to a 2% tax on debt flows or equivalent quantity regulations. In advanced countries where the risk of contractionary exchange rate depreciations is more limited, the role for capital controls subsides. However, macroprudential regulation remains essential to mitigate booms and busts in asset prices.(This abstract was borrowed from another version of this item.)