Working Paper: NBER ID: w21791
Authors: Michael B. Devereux; Eric R. Young; Changhua Yu
Abstract: The dangers of high capital flow volatility and sudden stops have led economists to promote the use of capital controls as an addition to monetary policy in emerging market economies. This paper studies the benefits of capital controls and monetary policy in an open economy with financial frictions, nominal rigidities, and sudden stops. We focus on a time-consistent policy equilibrium. We find that during a crisis, an optimal monetary policy should sharply diverge from price stability. Without commitment, policymakers will also tax capital inflows in a crisis. But this is not optimal from an ex-ante social welfare perspective. An outcome without capital inflow taxes, using optimal monetary policy alone to respond to crises, is superior in welfare terms, but not time-consistent. If policy commitment were in place, capital inflows would be subsidized during crises. We also show that an optimal policy will never involve macro-prudential capital inflow taxes as a precaution against the risk of future crises (whether or not commitment is available).
Keywords: capital controls; monetary policy; sudden stops; emerging markets
JEL Codes: E44; E58; F38; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| optimal monetary policy should deviate from price stability (E63) | increase in domestic inflation (E31) |
| capital inflow taxes during crises (F38) | alleviate external borrowing constraints (F34) |
| capital inflow taxes (F21) | welfare-reducing in the long run (D69) |
| time-consistent equilibrium resulting from capital controls (F32) | excessively low asset prices (G19) |
| time-consistent equilibrium resulting from capital controls (F32) | inefficient levels of net external debt accumulation (H69) |
| absence of commitment (J22) | capital inflow taxes are counterproductive (F21) |
| if commitment were possible (D70) | optimal policies would involve subsidizing capital inflows during crises (F32) |