Dealing with the Trilemma: Optimal Capital Controls with Fixed Exchange Rates

95 Pages Posted: 29 Jun 2012

See all articles by Emmanuel Farhi

Emmanuel Farhi

Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

Iván Werning

Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: June 2012

Abstract

We lay down a standard macroeconomic model of a small open economy with a fixed exchange rate and study optimal capital controls (defined as maximizing the utility of a representative household). We provide sharp analytical and numerical characterizations for a variety of shocks. We find that capital controls are employed to respond to some shocks but not others. They are particularly effective to address risk-premium shocks that affect the interest rate differential foreign investors require in a particular country. We also discuss how the solution depends on the degree of nominal rigidity and the openness of the economy. We show that capital controls may be optimal even if the exchange rate is not fixed in response to risk premium shocks or if wages, in addition to prices, are sticky. Finally, we compare the single country's optimum to a coordinated world solution. Our results show a limited need for coordination. However, the uncoordinated solution features the same capital controls as the coordinated solution.

Suggested Citation

Farhi, Emmanuel and Werning, Ivan, Dealing with the Trilemma: Optimal Capital Controls with Fixed Exchange Rates (June 2012). NBER Working Paper No. w18199, Available at SSRN: https://ssrn.com/abstract=2096012

Emmanuel Farhi (Contact Author)

Harvard University - Department of Economics ( email )

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National Bureau of Economic Research (NBER) ( email )

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Ivan Werning

Massachusetts Institute of Technology (MIT) - Department of Economics ( email )

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HOME PAGE: http://econ-www.mit.edu/faculty/iwerning

National Bureau of Economic Research (NBER) ( email )

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