The Effect of Capital Controls on Interest Rate Differentials

In this paper we present a model of international interest rate arbitrage under conditions of entry and exit costs to and from the domestic capital market. We seek to measure the maximum potential effect of capital controls, such as non-interest paying reserve requirements, on interest rate differentials. We quantify the effect of such taxes using a dynamic optimization model with uncertainty and transaction costs. An optimal (S,s) rule gives the limits for interest rate differentials that trigger massive capital inflows and outflows. We also calculate maximum sustainable interest rate differentials for various maturities and study the effect of parameter changes. Using parameters estimated for the Chilean economy, the model shows that the effect of capital controls on interest rate differentials is considerably smaller than what static calculations suggest.