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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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    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. Lahiri, Amartya & Singh, Rajesh & Vegh, Carlos, 2007. "Segmented asset markets and optimal exchange rate regimes," Journal of International Economics, Elsevier, vol. 72(1), pages 1-21, May.
    2. Fender, John & Yip, Chong K., 2000. "Tariffs and exchange rate dynamics redux," Journal of International Money and Finance, Elsevier, vol. 19(5), pages 633-655, October.
    3. 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.
    4. 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.
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    6. Lane, Philip R. & Milesi-Ferretti, Gian Maria, 2007. "The external wealth of nations mark II: Revised and extended estimates of foreign assets and liabilities, 1970-2004," Journal of International Economics, Elsevier, vol. 73(2), pages 223-250, November.
    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. 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.
    9. Philip Lane & Gian Maria Milesi-Ferretti, 2001. "THE EXTERNAL WEALTH OF NATIONS: Measures of Foreign Assets and Liabilities For Industrial and Developing Countries," Trinity Economics Papers 20014, Trinity College Dublin, Department of Economics.
    10. A Alesina & V Grilli & G Milesi-Feretti, 1993. "The Political Economy of Capital Controls," CEP Discussion Papers dp0169, Centre for Economic Performance, LSE.
    11. Jacob A. Frenkel & Assaf Razin, 1986. "The Limited Viability of Dual Exchange-Rate Regimes," NBER Working Papers 1902, National Bureau of Economic Research, Inc.
    12. Reinhart, Carmen & Smith, R Todd, 2002. "Temporary controls on capital inflows," MPRA Paper 13863, University Library of Munich, Germany.
    13. Luis Felipe Céspedes & Roberto Chang & Andrés Velasco, 2004. "Balance Sheets and Exchange Rate Policy," American Economic Review, American Economic Association, vol. 94(4), pages 1183-1193, September.
    14. Robert P. Flood & Nancy Peregrim Marion, 1982. "The Transmission of Disturbances under Alternative Exchange-Rate Regimes with Optimal Indexing," The Quarterly Journal of Economics, Oxford University Press, vol. 97(1), pages 43-66.
    15. V. V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 1998. "Can sticky price models generate volatile and persistent real exchange rates?," Staff Report 223, Federal Reserve Bank of Minneapolis.
    16. 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.
    17. 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.
    18. Levy-Yeyati, Eduardo & Sturzenegger, Federico, 2005. "Classifying exchange rate regimes: Deeds vs. words," European Economic Review, Elsevier, vol. 49(6), pages 1603-1635, August.
    19. 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.
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