Are Capital Controls in the Foreign Exchange Market Effective?

Abstract

One of the reasons for governments to employ capital controls is to obtain some degree of monetary independence. In this paper we test whether capital controls can reduce the link between exchange rates fluctuations and cross border interest differentials. The standard IMF dummy is used together with two more refined capital control proxies in order to determine the date of capital account liberalization for a panel of Western European and emerging countries. Results show that capital controls do not give governments extra monetary freedom. For a number of countries we even find a decrease in the level of monetary freedom as a result of capital controls.

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

JEL Classification: E42, F21, F31, G15