The Prudential Use of Capital Controls and Foreign Currency Reserves
We provide a simple framework to study the prudential use of capital controls and currency reserves that have been explored in the recent literature. We cover the role of both pecuniary externalities and aggregate demand externalities. The model features a central policy dilemma for emerging economies facing large capital outflows: the choice between increasing the policy rate to stabilize the exchange rate and decreasing the policy rate to stabilize employment. Ex ante capital controls and reserve accumulation can help mitigate this dilemma. We use our framework to survey the recent literature and provide an overview of recent empirical findings on the use of these policies.
This paper has been prepared for the Handbook of International Economics, Volume V, edited by Gita Gopinath, Elhanan Helpman and Kenneth Rogoff. We are grateful to Gita Gopinath, Pierre-Olivier Gourinchas, Anton Korinek, Ken Rogoff, and Ludwig Straub for very useful comments. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis, the Federal Reserve System, or the National Bureau of Economic Research.