Optimal Capital Controls and Real Exchange Rate Policies: A Pecuniary Externality Perspective

56 Pages Posted: 2 Jun 2014

See all articles by Gianluca Benigno

Gianluca Benigno

London School of Economics & Political Science (LSE) - Department of Economics; Federal Reserve Bank of New York

Huigang Chen

MarketShare Partners

Chris Otrok

University of Missouri; Federal Reserve Banks - Federal Reserve Bank of St. Louis

Alessandro Rebucci

Johns Hopkins University - Carey Business School; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Eric R. Young

University of Virginia

Multiple version iconThere are 3 versions of this paper

Date Written: April 2014

Abstract

In response to the global financial crisis a new policy paradigm emerged in which capital controls and other quantitative restrictions on credit flows have become part of the standard crisis prevention policy toolkit. A new strand of theoretical literature studies the use of capital controls in a context in which pecuniary externality justifies policy interventions. Within the same theoretical framework adopted in this literature, we show that the optimal design of crisis prevention (ex-ante) policies depends on the effectivness of crisis management (ex-post) policies. This interaction between ex-ante and ex-post policies gives rise to a new rationale for the use of capital controls. Specifically, we show that when ex-post policies are effective in containing crises, there is no need to intervene ex-ante with capital controls. On the other hand, if crises management policies entail efficiency costs and hence lose effectiveness, then the optimal policy mix consists of both ex-ante and ex-post interventions so that crises prevention policies become desirable. In our model, the optimal policy mix combines capital controls in tranquil times with real exchange rate support to limit its depreciation during crises times and yields welfare gains of more than 1% in consumption equivalence terms.

Keywords: Capital Controls, Financial Crises, Financial Frictions, Macro-prudential policies, Pecuniary Externality, Real Exchange Rate

JEL Classification: E52, F37, F41

Suggested Citation

Benigno, Gianluca and Benigno, Gianluca and Chen, Huigang and Otrok, Christopher and Rebucci, Alessandro and Young, Eric R., Optimal Capital Controls and Real Exchange Rate Policies: A Pecuniary Externality Perspective (April 2014). CEPR Discussion Paper No. DP9936, Available at SSRN: https://ssrn.com/abstract=2444959

Gianluca Benigno (Contact Author)

London School of Economics & Political Science (LSE) - Department of Economics ( email )

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Federal Reserve Bank of New York ( email )

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Huigang Chen

MarketShare Partners ( email )

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Christopher Otrok

University of Missouri ( email )

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Alessandro Rebucci

Johns Hopkins University - Carey Business School ( email )

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National Bureau of Economic Research (NBER) ( email )

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Centre for Economic Policy Research (CEPR) ( email )

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Eric R. Young

University of Virginia ( email )

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