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.
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- Luis Oscar Herrera & Rodrigo Valdés, 1999.
"The Effect of Capital Controls on Interest Rate Differentials,"
Working Papers Central Bank of Chile
50, Central Bank of Chile.
- Herrera, Luis Oscar & Valdes, Rodrigo O., 2001. "The effect of capital controls on interest rate differentials," Journal of International Economics, Elsevier, vol. 53(2), pages 385-398, April.
- Herrera, L.O. & Valdes, R., 1999. "The Effect of Capital Controls on Interest Rate Differentials," Papers 50, Cambridge - Risk, Information & Quantity Signals.
- Samuel Bentolila & Giuseppe Bertola, 1990. "Firing Costs and Labour Demand: How Bad is Eurosclerosis?," Review of Economic Studies, Oxford University Press, vol. 57(3), pages 381-402.
- Dixit, A., 1988.
"Entry And Exit Decisions Under Uncertainty,"
91, Princeton, Department of Economics - Financial Research Center.
- Eliane A. Cardoso & Ilan Goldfajn, 1997.
"Capital Flows to Brazil; The Endogeneity of Capital Controls,"
IMF Working Papers
97/115, International Monetary Fund.
- Eliana Cardoso & Ilan Goldfajn, 1998. "Capital Flows to Brazil: The Endogeneity of Capital Controls," IMF Staff Papers, Palgrave Macmillan, vol. 45(1), pages 161-202, March.
- Salvador ValdÃ©s-Prieto & Marcelo Soto, 1998. "The Effectiveness of Capital Controls: Theory and Evidence from Chile," Empirica, Springer;Austrian Institute for Economic Research;Austrian Economic Association, vol. 25(2), pages 133-164, January.
- Cardenas, Mauricio & Barrera, Felipe, 1997. "On the effectiveness of capital controls: The experience of Colombia during the 1990s," Journal of Development Economics, Elsevier, vol. 54(1), pages 27-57, October.
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