Capital Flows, Beliefs, and Capital Controls

Belief heterogeneity generates speculative cross-border capital flows that are much larger than flows generated by the hedging/insurance motives. We show theoretically that limiting financial trades may gen- erate welfare gains despite inhibiting insurance possibilities. Financial constraints tame speculation forces, limit movements of the net for- eign wealth positions, and thus reduce consumption volatility. This provides a novel justification for capital controls. Simulations indicate that welfare gains from imposing capital con- trols can be substantial, equivalent to a permanent consumption in- crease of up to 4%, or 80 times the cost of business cycles. Controls that activate only during substantial inflows or outflows are preferred to those constantly active, e.g. a transaction tax used by some emerg- ing market economies. Yet, despite improving macroeconomic stability capital controls may unintentionally lead to increased volatility in the domestic financial markets.


Issue Date:
2016-04
Publication Type:
Working or Discussion Paper
PURL Identifier:
http://purl.umn.edu/250031
Total Pages:
34
JEL Codes:
F32
Series Statement:
WP
16-09




 Record created 2017-04-01, last modified 2018-01-23

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