Working Paper: NBER ID: w18199
Authors: Emmanuel Farhi; Ivan Werning
Abstract: We lay down a standard macroeconomic model of a small open economy with a fixed exchange rate and study optimal capital controls (defined as maximizing the utility of a representative household). We provide sharp analytical and numerical characterizations for a variety of shocks. We find that capital controls are employed to respond to some shocks but not others. They are particularly effective to address risk-premium shocks that affect the interest rate differential foreign investors require in a particular country. We also discuss how the solution depends on the degree of nominal rigidity and the openness of the economy. We show that capital controls may be optimal even if the exchange rate is not fixed in response to risk premium shocks or if wages, in addition to prices, are sticky. Finally, we compare the single country's optimum to a coordinated world solution. Our results show a limited need for coordination. However, the uncoordinated solution features the same capital controls as the coordinated solution.
Keywords: capital controls; fixed exchange rates; macroeconomic stability; risk premium shocks
JEL Codes: E5; F3; F32; F33; F41; F42
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| capital controls (F38) | effectiveness in addressing risk premium shocks (G17) |
| degree of nominal rigidity (D10) | optimal use of capital controls (F38) |
| openness of the economy (F41) | optimal use of capital controls (F38) |
| capital controls (F38) | stabilize the economy (E63) |
| risk premium shocks (G19) | interest rate differential required by foreign investors (F21) |
| flexible exchange rate (F31) | optimal use of capital controls in response to risk premium shocks (F32) |
| sticky wages (J31) | optimal use of capital controls in response to risk premium shocks (F32) |
| capital controls (F38) | enhance monetary autonomy (E42) |
| capital controls (F38) | stabilize consumption and output (E20) |