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Abstract

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.

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