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Optimal Capital Controls and Real Exchange Rate Policies: A Pecuniary Externality Perspective

Author

Listed:
  • Gianluca Benigno

    () (London School of Economics (LSE)
    Centre for Macroeconomics (CFM))

  • Huigang Chen

    (MarketShare Partners)

  • Christopher Otrok

    () (Economics Department University of Missouri
    Research Division Federal Reserve Bank of St. Louis)

  • Alessandro Rebucci

    () (Carey Business School Johns Hopkins University)

  • Eric R. Young

    () (Department of Economics University of Virginia)

Abstract

In response to the global financial crisis a new policy paradigm emerged in which capital controls and other quantitative restrictions on credit flows have become part of the standard crisis prevention policy toolkit. A new strand of theoretical literature studies the use of capital controls in a context in which pecuniary externality justifies policy interventions. Within the same theoretical framework adopted in this literature, we show that the optimal design of crisis prevention (ex-ante) policies depends on the effectiviness of crisis management (ex-post) policies. This interaction between ex-ante and ex-post policies gives rise to a new rationale for the use of capital controls. Specifically, we show that when ex-post policies are effective in containing crises, there is no need to intervene ex-ante with capital controls. On the other hand, if crises management policies entail efficiency costs and hence lose effectiveness, then the optimal policy mix consists of both ex-ante and ex-post interventions so that crises prevention policies become desirable. In our model, the optimal policy mix combines capital controls in tranquil times with real exchange rate support to limit its depreciation during crises times and yields welfare gains of more than 1% in consumption equivalence terms.

Suggested Citation

  • Gianluca Benigno & Huigang Chen & Christopher Otrok & Alessandro Rebucci & Eric R. Young, 2011. "Optimal Capital Controls and Real Exchange Rate Policies: A Pecuniary Externality Perspective," Discussion Papers 1512, Centre for Macroeconomics (CFM), revised Feb 2015.
  • Handle: RePEc:cfm:wpaper:1512
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Capital Controls; Real Exchange Rate Policy; Financial Frictions; Financial Crises; Financial Stability; Optimal Taxation; Macro-Prudential Policies;

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation: Models and Applications
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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