Capital Controls or Exchange Rate Policy? A Pecuniary Externality Perspective
FRB of St. Louis Working Paper No. 2012-025A
27 Pages Posted: 2 Aug 2012
Date Written: July 28, 2012
In the aftermath of the global financial crisis, a new policy paradigm has emerged in which old-fashioned policies such as capital controls and other government distortions have become part of the standard policy toolkit (the so-called macro-prudential policies). On the wave of this seemingly unanimous policy consensus, a new strand of theoretical literature contends that capital controls are welfare enhancing and can be justified rigorously because of second-best considerations. Within the same theoretical framework adopted in this fast-growing literature, we show that a credible commitment to support the exchange rate in crisis times always welfare-dominates prudential capital controls as it can achieve the first best unconstrained allocation. In this benchmark economy, prudential capital controls are optimal only when the set of policy tools is restricted so that they are the only policy instrument available.
Keywords: Capital Controls, Exchange Rate Policy, Financial Frictions, Financial Crises, Financial Stability, Optimal Taxation, Prudential Policies, Planning Problem
JEL Classification: E52, F37, F41
Suggested Citation: Suggested Citation