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How do Capital Controls Affect the Transmission of Foreign Shocks?

  • Dudley Cooke

    (University of Essex)

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    This paper studies the short-run transmission of foreign shocks in a small open economy with capital controls and a fixed exchange rate. Capital controls alter the transmission of shocks because endogenous changes in the domestic nominal interest rate affect savings and investment decisions. The economy's reaction to export shocks hinges on how the government chooses to restrict capital flows; that is, whether inflows or outflows are restricted. For foreign interest rate shocks, private capital flows are important, but so are the government's holdings of foreign exchange reserves. Finally, a simple graphical apparatus is developed to provide a contrast to the case when capital flows are unrestricted.

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    File URL: http://www.econ.ku.dk/eprn_epru/Workings_Papers/wp-07-02.pdf
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    Paper provided by Economic Policy Research Unit (EPRU), University of Copenhagen. Department of Economics in its series EPRU Working Paper Series with number 07-02.

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    Length: 20 pages
    Date of creation: Apr 2007
    Date of revision:
    Handle: RePEc:kud:epruwp:07-02
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    1. Luis Felipe Cespedes & Roberto Chang & Andres Velasco, 2000. "Balance Sheets and Exchange Rate Policy," NBER Working Papers 7840, National Bureau of Economic Research, Inc.
    2. Guidotti, Pablo E. & Vegh, Carlos A., 1992. "Macroeconomic interdependence under capital controls : A two-country model of dual exchange rates," Journal of International Economics, Elsevier, vol. 32(3-4), pages 353-367, May.
    3. V.V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2000. "Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?," NBER Working Papers 7869, National Bureau of Economic Research, Inc.
    4. Gian-Maria Milesi-Ferretti & Philip R. Lane, 1999. "The External Wealth of Nations; Measures of Foreign Assets and Liabilities for Industrial and Developing Countries," IMF Working Papers 99/115, International Monetary Fund.
    5. Robert P. Flood & Nancy Peregrim Marion, 1980. "The Transmission of Disturbances under Alternative Exchange-Rate Regimeswith Optimal Indexing," NBER Working Papers 0500, National Bureau of Economic Research, Inc.
    6. Carmen M. Reinhart & Kenneth S. Rogoff, 2002. "The Modern History of Exchange Rate Arrangements: A Reinterpretation," NBER Working Papers 8963, National Bureau of Economic Research, Inc.
    7. Reinhart, Carmen & Calvo, Guillermo & Vegh, Carlos, 1994. "Targeting the real exchange rate: Theory and evidence," MPRA Paper 13412, University Library of Munich, Germany.
    8. John Fender & Chong K. Yip, 1998. "Tariffs and Exchange Rate Dynamics Redux," Departmental Working Papers _105, Chinese University of Hong Kong, Department of Economics.
    9. Philip R. Lane & Gian Maria Milesi-Ferretti, 2006. "The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities,1970–2004," The Institute for International Integration Studies Discussion Paper Series iiisdp126, IIIS.
    10. Enrique G. Mendoza, 1991. "Capital Controls and the Gains from Trade in a Business Cycle Model of a Small Open Economy," IMF Staff Papers, Palgrave Macmillan, vol. 38(3), pages 480-505, September.
    11. Carmen M. Reinhart & R. Todd Smith, 2001. "Temporary Controls on Capital Inflows," NBER Working Papers 8422, National Bureau of Economic Research, Inc.
    12. Jacob A. Frenkel & Assaf Razin, 1986. "The Limited Viability of Dual Exchange-Rate Regimes," NBER Working Papers 1902, National Bureau of Economic Research, Inc.
    13. A Alesina & V Grilli & G Milesi-Feretti, 1993. "The Political Economy of Capital Controls," CEP Discussion Papers dp0169, Centre for Economic Performance, LSE.
    14. Jacques Miniane & John H. Rogers, 2007. "Capital Controls and the International Transmission of U.S. Money Shocks," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(5), pages 1003-1035, 08.
    15. Marion, Nancy Peregrim, 1981. "Insulation Properties of a Two-Tier Exchange Market in a Portfolio Balance Model," Economica, London School of Economics and Political Science, vol. 48(189), pages 61-70, February.
    16. Adams, Charles & Greenwood, Jeremy, 1985. "Dual exchange rate systems and capital controls: An investigation," Journal of International Economics, Elsevier, vol. 18(1-2), pages 43-63, February.
    17. Amartya Lahiri & Rajesh Singh & Carlos A. Vegh, 2007. "Segmented Asset Markets and Optimal Exchange Rate Regimes," NBER Working Papers 13154, National Bureau of Economic Research, Inc.
    18. Alberto Alesina & Vittorio Grilli & Gian Maria Milesi-Ferrett, 1993. "The Political Economy of Capital Controls," NBER Working Papers 4353, National Bureau of Economic Research, Inc.
    19. Levy-Yeyati, Eduardo & Sturzenegger, Federico, 2005. "Classifying exchange rate regimes: Deeds vs. words," European Economic Review, Elsevier, vol. 49(6), pages 1603-1635, August.
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