A New Dilemma: Capital Controls and Monetary Policy in Sudden-Stop Economies

71 Pages Posted: 10 Mar 2016 Last revised: 26 Sep 2023

Multiple version iconThere are 2 versions of this paper

Date Written: March 2016

Abstract

This working paper was written by Michael B. Devereux (University of British Columbia), Eric R. Young (University of Virginia) and Changhua Yu (Peking University).

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, or a departure from price stability, as a precaution against the risk of future crises (whether or not commitment is available).

Keywords: Sudden stops, Pecuniary externality, Monetary policy, Capital controls, Time-consistency

JEL Classification: E44, E58, F38, F41

Suggested Citation

Institute for Monetary and Financial Research, Hong Kong, A New Dilemma: Capital Controls and Monetary Policy in Sudden-Stop Economies (March 2016). Hong Kong Institute for Monetary and Financial Research (HKIMR) Research Paper WP No. 03/2016, Journal of Monetary Economics, Vol. 103, 2019, Available at SSRN: https://ssrn.com/abstract=2744458 or http://dx.doi.org/10.2139/ssrn.2744458

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