Capital Controls and Free-Trade Agreements

How does the conduct of optimal cross-border financial policy change with prevailing trade agreements? We study the joint optimal determination of trade policy and capital-flow management in a two-country, two-good model with trade in goods and assets. While the cooperative optimal allocation is efficient and involves no intervention, a country-planner acting unilaterally can achieve higher domestic welfare at the expense of the rest of the world by departing from free trade in addition to levying capital controls, absent retaliation from abroad. However, time variation in the optimal tariff induces households to over- or under-borrow through its effects on the real exchange rate. In response to fluctuations where incentives for the planner to manipulate the terms of trade inter- and intra-temporallyare aligned—e.g., the availability of domestic goods changes, or when faced with trade disruptions to imports—optimal capital controls are larger when used in conjunction with optimal tariffs. In contrast, when the incentives are misaligned, the optimal trade tariff partly substitutes for the use of capital controls. Accounting for strategic retaliation, we show that committing to a free-trade agreement can reduce incentives to engage in costly capital-control wars for both countries.