Abstract
A new literature studies the use of capital controls to prevent financial crises. Within this new framework, we show that when exchange rate policy is costless, there is no need for capital controls. However, if exchange rate policy entails efficiency costs, capital controls become part of the optimal policy mix. When exchange rate policy is costly, the optimal mix combines prudential capital controls in tranquil times with policies that limit exchange rate depreciation in crisis times. The optimal mix yields more borrowing, fewer and less severe financial crises, and much higher welfare than with capital controls alone.
Highlights
In response to the global ...nancial crisis and its costly aftermath, a new policy paradigm emerged in which old fashioned government policies such as capital controls and other restrictions on credit ‡ows became part of the standard crisis prevention policy toolkit
We provide an integrated analysis of alternative policy tools that can be interpreted in terms of ...scal, monetary and macroprudential policies using the same model economy studied by Bianchi (2011)
In response to the recent global ...nancial crisis, a new policy paradigm emerged in which old fashioned forms of government interventions such as capital controls and other quantitative restrictions on credit ‡ows— the so called macro-prudential policies— have become part of the standard policy toolkit
Summary
In response to the global ...nancial crisis and its costly aftermath, a new policy paradigm emerged in which old fashioned government policies such as capital controls and other restrictions on credit ‡ows became part of the standard crisis prevention policy toolkit (the so called macro-prudential policies). The key rationale underpinning the use of capital controls is ...nancial stability.[1, 2] The ...nancial stability motive is the focus of the in‡uential contributions of Korinek (2010) and Bianchi (2011).[3] Their analysis is based on variants of a common theoretical framework proposed by Mendoza (2002, 2010) In this framework, the scope for policy intervention arises because of a pecuniary externality stemming from the presence of a key relative price in the collateral constraint faced by private agents. Ottonello (2015) studies optimal exchange rate policy with downward nominal wage rigidity, ‡exible exchange rates, and a borrowing constraint like the one in our model His analysis focuses on a restricted set of instruments similar to Jeanne and Korinek (2013) and discusses the trade-o¤s that exchange rate policy faces between competitiveness and ...nancial stability considerations. The numerical solution methods we use as well as other technical material including proofs and extensions are reported in an appendix for online publication
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