Are Capital Controls in the Foreign Exchange Market Effective?

Abstract

One of the reasons for governments to use capital controls is to obtain some degree of monetary independence. This paper investigates the link between capital controls and interest differentials/forward premia. This to test whether they can indeed give governments the power to drive exchange rates away from parity conditions. Two capital control variables are constructed in addition to the standard IMF capital control dummy. These variables are used to determine the date of capital account liberalization in a panel of Western European as well as emerging countries. Results show that capital controls do not give governments extra monetary freedom. There is even some evidence that capital controls decrease the level of monetary freedom governments enjoy for a number of countries.

Keywords: Capital controls, Exchange Rates, Forward premia, Interest differentials, Monetary freedom

JEL Classification: E42, F21, F31, G15