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Capital Controls or Exchange Rate Policy? A Pecuniary Externality Perspective

  • Gianluca Benigno
  • Huigang Chen
  • Christopher Otrok
  • Alessandro Rebucci
  • Eric R. Young

In the aftermath of the global financial crisis, a new policy paradigm has emerged in which old-fashioned policies such as capital controls and other government distortions have become part of the standard policy toolkit (the so-called macro-prudential policies). On the wave of this seemingly unanimous policy consensus, a new strand of theoretical literature contends that capital controls are welfare enhancing and can be justified rigorously because of second-best considerations. Within the same theoretical framework adopted in this fast-growing literature, we show that a credible commitment to support the exchange rate in crisis times always welfare-dominates prudential capital controls as it can achieve the first best unconstrained allocation. In this benchmark economy, prudential capital controls are optimal only when the set of policy tools is restricted so that they are the only policy instrument available.

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Paper provided by Centre for Economic Performance, LSE in its series CEP Discussion Papers with number dp1160.

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Date of creation: Aug 2012
Date of revision:
Handle: RePEc:cep:cepdps:dp1160
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  1. 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.
  2. Paul Krugman, 1999. "Balance Sheets, the Transfer Problem, and Financial Crises," International Tax and Public Finance, Springer, vol. 6(4), pages 459-472, November.
  3. Enrique G. Mendoza & Javier Bianchi, 2010. "Overborrowing, financial crises and ‘macro-prudential’ taxes," Proceedings, Federal Reserve Bank of San Francisco, issue Oct.
  4. Bianca De Paoli & Anna Lipinska, 2013. "Capital controls: a normative analysis," Staff Reports 600, Federal Reserve Bank of New York.
  5. Nicolas E. Magud E. & Carmen M. & Kenneth S. Rogoff, 2011. "Capital Controls: Myth and Reality--A Portfolio Balance Approach," Working Paper Series WP11-7, Peterson Institute for International Economics.
  6. Bianchi, Javier, 2009. "Overborrowing and Systemic Externalities in the Business Cycle," MPRA Paper 16270, University Library of Munich, Germany.
  7. Luis Felipe Céspedes & Roberto Chang & Diego Saravia, 2010. "Monetary Policy Under Financial Turbulence: an Overview," Working Papers Central Bank of Chile 594, Central Bank of Chile.
  8. Timothy J. Kehoe & David K. Levine, 1993. "Debt-Constrained Asset Markets," Review of Economic Studies, Oxford University Press, vol. 60(4), pages 865-888.
  9. Gianluca Benigno & Huigang Chen & Chris Otrok & Alessandro Rebucci & Eric Young, 2010. "Revisiting Overborrowing and Its Policy Implications," CEP Discussion Papers dp1020, Centre for Economic Performance, LSE.
  10. Benigno, Gianluca & Chen, Huigang & Otrok, Christopher & Rebucci, Alessandro & Young, Eric R., 2013. "Financial crises and macro-prudential policies," Journal of International Economics, Elsevier, vol. 89(2), pages 453-470.
  11. Bruce Ian Carlin & Shaun William Davies & Andrew Miles Iannaccone, 2010. "Competing for Attention in Financial Markets," NBER Working Papers 16085, National Bureau of Economic Research, Inc.
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