Capital Controls as an Instrument of Monetary Policy

Abstract

Large swings in capital flows into and out of emerging markets can potentially lead to excessive volatility in asset prices and credit supply. In order to lessen the impact of capital flows on financial instability, a number of researchers and policy markers have recently proposed the use of capital controls. This paper considers the benefit of adding capital controls as a potential instrument of monetary policy in a small open economy. In a DSGE framework, we find that when domestic agents are subject to collateral constraints and the value of collateral is subject to fluctuations driven by foreign capital inflows and outflows, the adoption of temporary capital controls can lead to a significant welfare improvement. The benefits of capital controls are present even when monetary policy is determined optimally, implying that there may be a role for capital controls to exist side-by-side with conventional monetary tools as an instrument of monetary policy.

Measuring sovereign risk spillovers and assessing the role of transmission channels: A spatial econometrics approach

“…A smaller but promising strand of the literature has attempted to combine the two previous dimensions, i.e. two-country DSGE models with financial frictions, with however a focus that is not directly to quantify spillover effects, (see Faia 2007, Davis & Presno 2014, Yao 2012. More recently, Justiniano & Preston (2010) and Alpanda & Aysun (2014) have provided dedicated studies to document co-movements in economic fluctuations and potential transmission channels within this open-DSGE family models.…”

Capital Controls, Monetary Policy, and Balance Sheets in a Small Open Economy

“…Our paper is most closely related to De Paoli and Lipinska (), Davis and Presno (), and Liu and Spiegel () in that we too apply a Ramsey‐type analysis for capital controls. However, we examine optimal capital controls in models that highlight balance sheet effects in the presence of liability dollarization .…”

“…Another strand of the literature focuses the relationship between capital controls and various types of monetary policies (Agénor and Jia ; Chang, Liu, and Spiegel ; Davis and Presno ; Liu and Spiegel ). For example, Kitano and Takaku () show that capital controls can play an alternative role to the direct credit policy in mitigating the contraction after a crisis.…”

Capital controls and welfare with cross-border bank capital flows

“…More recent analytical contributions have focused on the role of capital controls as a prudential instrument, or as a tool to reduce the probability of financial crises. These contributions include Bianchi (2011), Bianchi and Mendoza (2011), Farhi and Werning (2012), Schmitt-Grohé and Uribe (2012), De Paoli and Lipinska (2013), Costinot et al (2014), Kitano and Takaku (2014), Korinek and Sandri (2014), Brunnermeier and Sannikov (2015), Heathcote and Perri (2016), Davis and Presno (2017), Chang et al (2015), and Benigno et al (2016).…”

“…1 Our analysis differs from existing studies in several important ways. First, as in Escudé (2014), Kitano and Takaku (2014), Chang et al (2015) and Davis and Presno (2017), we use an open-economy stochastic general equilibrium model to study the benefits of time-varying capital controls. However, unlike these contributions, but in line with Benigno et al (2016), we do so in a model with financial frictions, a feature that is important to understand some of the negative externalities associated with capital flows from the perspective of financial volatility, such as excessive credit growth or asset price pressures.…”