Optimal Capital Controls and Real Exchange Rate Policies: A Pecuniary Externality Perspective
65 Pages Posted: 9 May 2016 Last revised: 23 Sep 2022
Date Written: May 2016
A new theoretical literature studies the use of capital controls to prevent financial crises in models in which pecuniary externalities justify government intervention. Within the same theoretical framework, we show that when ex-post policies such as defending the exchange rate can contain or resolve financial crises, there is no need to intervene ex-ante with capital controls. On the other hand, if crises management policies entail some efficiency costs, then crises prevention policies become part of the optimal policy mix. In the standard model economy used in the literature with costly crisis management policies, the optimal policy mix combines capital controls in tranquil times with support for the real exchange rate to limit its depreciation during crises times. The optimal policy mix yields more borrowing and consumption, a lower probability of financial crisis, and twice as large welfare gains than in the socially planned equilibrium with capital controls alone.
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