Capital Controls as Macro-Prudential Policy in a Large Open Economy

58 Pages Posted: 1 Apr 2019

See all articles by Scott Davis

Scott Davis

Federal Reserve Banks - Federal Reserve Bank of Dallas

Michael B. Devereux

University of British Columbia (UBC) - Department of Economics; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 2 versions of this paper

Date Written: March 2019

Abstract

The use of international capital flow controls has become increasingly popular in academic and policy circles. But almost all the recent literature studies the case of a small economy, ignoring the spillover effects of capital controls to the rest of the world. This paper re-examines the case for capital controls in a large open economy, where domestic financial constraints may bind following a large negative shock. We consider both ex-ante capital controls (prudential) and ex-post controls (crisis management). In a large open economy, there is a tension between the desire to tax capital inflows to manipulate the terms-of-trade and tax capital outflows for either prudential or crisis management purposes. When capital controls are chosen non-cooperatively, we show that ex-post capital controls are unsuccessful in alleviating financial constraints in a crisis, and ex-ante capital controls are unsuccessful at reducing financial instability before the crisis. Non-cooperative capital controls leave the crisis-hit country even worse off than in an environment with unrestricted capital flows. In addition, a non-cooperative equilibrium with capital controls actually increases the likelihood of a financial crisis occurring. By contrast, capital controls can be effective under international cooperation and can significantly ease financial constraints when applied ex-post for crisis management and reduce the likelihood of a crisis when used ex-ante for prudential purposes.

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Suggested Citation

Davis, Scott and Devereux, Michael B., Capital Controls as Macro-Prudential Policy in a Large Open Economy (March 2019). NBER Working Paper No. w25710. Available at SSRN: https://ssrn.com/abstract=3363448

Scott Davis (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Dallas ( email )

2200 North Pearl Street
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Dallas, TX 75265-5906
United States

Michael B. Devereux

University of British Columbia (UBC) - Department of Economics ( email )

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Vancouver, BC V6T 1Z1
Canada
604-822-2542 (Phone)
604-946-6271 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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