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Capital Control, Exchange Rate Regime, and Monetary Policy: Indeterminacy and Bifurcation

Author

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  • William Barnett

    (Department of Economics, University of Kansas; Center for Financial Stability, New York City; IC2 Institute, University of Texas at Austin)

  • Jingxian Hu

    (Department of Economics, University of Kansas;)

Abstract

Will capital controls enhance macro economy stability? How will the results be influenced by the exchange rate regime and monetary policy reaction? Are the consequences of policy decisions involving capital controls easily predictable, or more complicated than may have been anticipated? We will answer the above questions by investigating the macroeconomic dynamics of a small open economy. In recent years, these matters have become particularly important to emerging market economies, which have often adopted capital controls. We especially investigate two dynamical characteristics: indeterminacy and bifurcation. Four cases are explored, based on different exchange rate regimes and monetary policy rules. With capital controls in place, we find that indeterminacy depends upon how inflation and output gap coordinate with each other in their feedback to interest rate setting in the Taylor rule. When forward-looking, both passive and positive monetary policy feedback can lead to indeterminacy. Compared with flexible exchange rates, fixed exchange rate regimes produce more complex indeterminacy conditions, depending upon the stickiness of prices and the elasticity of substitution between labor and consumption. We find Hopf bifurcation under capital control with fixed exchange rates and current-looking monetary policy. To determine empirical relevance, we test indeterminacy empirically using Bayesian estimation. Fixed exchange rate regimes with capital controls produce larger posterior probability of the indeterminate region than a flexible exchange rate regime. Fixed exchange rate regimes with current-looking monetary policy lead to several kinds of bifurcation under capital controls. We provide monetary policy suggestions on achieving macroeconomic stability through financial regulation.

Suggested Citation

  • William Barnett & Jingxian Hu, 2017. "Capital Control, Exchange Rate Regime, and Monetary Policy: Indeterminacy and Bifurcation," WORKING PAPERS SERIES IN THEORETICAL AND APPLIED ECONOMICS 201706, University of Kansas, Department of Economics, revised Sep 2017.
  • Handle: RePEc:kan:wpaper:201706
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    More about this item

    Keywords

    Capital controls; open economy monetary policy; exchange rate regimes; Bayesian methods; bifurcation; indeterminacy.;
    All these keywords.

    JEL classification:

    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F38 - International Economics - - International Finance - - - International Financial Policy: Financial Transactions Tax; Capital Controls
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General
    • C62 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Existence and Stability Conditions of Equilibrium

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