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Capital Controls, Global Liquidity Traps and the International Policy Trilemma

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  • Michael B. Devereux
  • James Yetman

Abstract

The 'International Policy Trilemma' refers to the constraint on independent monetary policy that is forced on a country which remains open to international financial markets and simultaneously pursues an exchange rate target. This paper shows that, in a global economy with open financial markets, the problem of the zero bound introduces a new dimension to the international policy trilemma. International financial market openness may render monetary policy ineffective, even within a system of fully flexible exchange rates, because shocks that lead to a 'liquidity trap' in one country are propagated through financial markets to other countries. But monetary policy effectiveness may be restored by the imposition of capital controls, which inhibit the transmission of these shocks across countries. We derive an optimal monetary policy response to a global liquidity trap in the presence of capital controls. We further show that, even though capital controls may facilitate effective monetary policy, except in the case where monetary policy is further constrained (beyond the zero lower bound constraint), capital controls are not desirable in welfare terms.

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  • Michael B. Devereux & James Yetman, 2013. "Capital Controls, Global Liquidity Traps and the International Policy Trilemma," NBER Working Papers 19091, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:19091
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    Cited by:

    1. Acharya, Sushant & Bengui, Julien, 2018. "Liquidity traps, capital flows," Journal of International Economics, Elsevier, vol. 114(C), pages 276-298.
    2. Nicolas E. Magud & Carmen M. Reinhart & Kenneth S. Rogoff, 2018. "Capital Controls: Myth and Reality--A Portfolio Balance Approach," Annals of Economics and Finance, Society for AEF, vol. 19(1), pages 1-47, May.
    3. Jeffrey Frankel, 2021. "Systematic Managed Floating," World Scientific Book Chapters, in: Steven J Davis & Edward S Robinson & Bernard Yeung (ed.), THE ASIAN MONETARY POLICY FORUM Insights for Central Banking, chapter 5, pages 160-221, World Scientific Publishing Co. Pte. Ltd..
    4. Benigno, Gianluca & Chen, Huigang & Otrok, Christopher & Rebucci, Alessandro & Young, Eric R., 2016. "Optimal capital controls and real exchange rate policies: A pecuniary externality perspective," Journal of Monetary Economics, Elsevier, vol. 84(C), pages 147-165.
    5. Daeha Cho & Kwang Hwan & Sukjoon Kim, 2023. "The Paradox of Price Flexibility in an Open Economy," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 51, pages 370-392, December.
    6. McNelis, Paul D., 2016. "Optimal policy rules at home, crisis and quantitative easing abroad," BOFIT Discussion Papers 15/2016, Bank of Finland Institute for Emerging Economies (BOFIT).
    7. Jeffrey A. Frankel, 2016. "International Coordination," NBER Working Papers 21878, National Bureau of Economic Research, Inc.
    8. McNelis, Paul D., 2016. "Optimal policy rules at home, crisis and quantitative easing abroad," BOFIT Discussion Papers 15/2016, Bank of Finland, Institute for Economies in Transition.
    9. Caballero, Ricardo & Gourinchas, Pierre-Olivier & Farhi, Emmanuel, 2015. "Global Imbalances and Currency Wars at the ZLB," CEPR Discussion Papers 10905, C.E.P.R. Discussion Papers.
    10. Gauti B. Eggertsson & Neil R. Mehrotra & Sanjay R. Singh & Lawrence H. Summers, 2016. "A Contagious Malady? Open Economy Dimensions of Secular Stagnation," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 64(4), pages 581-634, November.
    11. Devereux, Michael B. & Yetman, James, 2014. "Globalisation, pass-through and the optimal policy response to exchange rates," Journal of International Money and Finance, Elsevier, vol. 49(PA), pages 104-128.
    12. Javier Bianchi & Louphou Coulibaly, 2021. "Liquidity Traps, Prudential Policies, and International Spillovers," Working Papers 780, Federal Reserve Bank of Minneapolis.
    13. Agénor, Pierre-Richard & Jia, Pengfei, 2020. "Capital controls and welfare with cross-border bank capital flows," Journal of Macroeconomics, Elsevier, vol. 65(C).
    14. Steiner, Andreas, 2017. "Central banks and macroeconomic policy choices: Relaxing the trilemma," Journal of Banking & Finance, Elsevier, vol. 77(C), pages 283-299.
    15. Kuersteiner, Guido M. & Phillips, David C. & Villamizar-Villegas, Mauricio, 2018. "Effective sterilized foreign exchange intervention? Evidence from a rule-based policy," Journal of International Economics, Elsevier, vol. 113(C), pages 118-138.
    16. Jean-Baptiste Michau, 2021. "Open Economy Secular Stagnation and Financial Integration," Working Papers 2021-19, Center for Research in Economics and Statistics.
    17. repec:zbw:bofitp:2016_015 is not listed on IDEAS
    18. Ricardo J Caballero & Emmanuel Farhi & Pierre-Olivier Gourinchas, 2021. "Global Imbalances and Policy Wars at the Zero Lower Bound [“Safe Assets”]," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 88(6), pages 2570-2621.
    19. DiGabriele, Jim & Ojo, Marianne, 2017. "The efficiency wage hypothesis and the role of corporate governance in firm performance," MPRA Paper 94914, University Library of Munich, Germany.
    20. Cho, Daeha & Kim, Kwang Hwan & Kim, Suk Joon, 2023. "Inefficient international risk-sharing," Journal of Monetary Economics, Elsevier, vol. 138(C), pages 31-49.
    21. Lim, G.C. & McNelis, Paul D., 2018. "Unconventional monetary and fiscal policies in interconnected economies: Do policy rules matter?," Journal of Economic Dynamics and Control, Elsevier, vol. 93(C), pages 346-363.
    22. Liliana Varela, 2018. "Reallocation, Competition, and Productivity: Evidence from a Financial Liberalization Episode," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 85(2), pages 1279-1313.
    23. Ippei Fujiwara, 2014. "Comments on Michael Devereux and James Yetman's paper," BIS Papers chapters, in: Bank for International Settlements (ed.), Globalisation, inflation and monetary policy in Asia and the Pacific, volume 77, pages 119-125, Bank for International Settlements.
    24. Sadat, Nafis, 2015. "Estimation of International Financial Integration: Evidence from European Countries," MPRA Paper 66283, University Library of Munich, Germany, revised 25 Aug 2015.

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    More about this item

    JEL classification:

    • F3 - International Economics - - International Finance
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions

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