The effects of capital controls on international capital flows in the presence of asymmetric information

Abstract

This paper examines the effects of capital controls on the volume and composition of international capital flows in the presence of asymmetric information. In the two-period, small open economy model, stochastic second-period output depends on the level of first-period investment, which cannot be verified by international investors. Domestic agents obtain external funding by borrowing on international capital markets and by selling equity to international investors. The paper investigates the effects of various capital controls on the debt–equity choice, domestic investment, and welfare. Controls on capital inflows are shown to shift the composition of flows from fixed-income instruments towards equity and to reduce the overall volume of inflows.