Capital Controls and Trade Policy

Abstract

How does the conduct of optimal cross-border financial policy change with prevailing trade agreements? We study the joint optimal determination of trade policy and capital- flow management in a two-country, two-good model with trade in goods and assets. While the cooperative optimal allocation is efficient, a country-planner can achieve higher domestic welfare by departing from free trade in addition to levying capital controls, absent retaliation from abroad. However, time variation in the optimal tariff induces households to over- or under-borrow through its effects on the path of the real exchange rate. As a result, optimal capital controls can be larger when used in conjunction with optimal tariffs in specific cases; and in others, the optimal trade tariff partly substitutes for the use of capital controls. Accounting for strategic retaliation, we show that committing to a free-trade agreement can reduce incentives to engage in costly capital-control wars for both countries.