Working Paper: NBER ID: w25710
Authors: J. Scott Davis; Michael B. Devereux
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.
Keywords: No keywords provided
JEL Codes: F40
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| capital controls (F38) | financial constraints (H60) |
| non-cooperative capital controls (F38) | likelihood of financial crisis (G01) |
| cooperative capital controls (P13) | likelihood of financial crisis (G01) |
| cooperative capital controls (P13) | financial constraints (H60) |
| capital controls (F38) | terms of trade (F14) |
| capital controls (F38) | global interest rates (E43) |