The Macroeconomics of Exchange Controls: Distortions, Resource Allocation, and Crisis Timing

Exchange controls are a common policy tool in emerging economies. This study develops a tractable model with capital accumulation to formalize their macroeconomic consequences in an environment where the government finances its deficit through domestic credit expansion while maintaining a fixed exchange rate. The analysis shows that exchange controls generate a wedge between official and parallel exchange rates, reduce output and permanent consumption, and, under certain conditions, tighter import restrictions can increase money demand and delay the collapse of the fixed rate regime. Moreover, the share of legal exports declines as the exchange rate gap widens. When import restrictions are endogenously adjusted in response to the amount of legal exports, domestic prices rise persistently over time. The main contributions are: (i) formalizing and summarizing the effects of exchange controls in a tractable model with capital accumulation and monetized deficits under a fixed exchange rate, and (ii) identifying a money-demand channel through which import restrictions can influence the timing of a first generation balance-of-payments crisis.