Eric Young

A new theoretical literature studies the use of capital controls to prevent financial crises in models in which pecuniary externalities justify government intervention. Within the same theoretical framework, we show that when ex-post policies such as defending the exchange rate can contain or resolve financial crises, there is no need to intervene ex-ante with capital controls. On the other hand, if crises management policies entail some efficiency costs, then crises prevention policies become part of the optimal policy mix. In the standard model economy used in the literature with costly crisis management policies, the optimal policy mix combines capital controls in tranquil times with support for the real exchange rate to limit its depreciation during crises times. The optimal policy mix...

Published: Gianluca Benigno & Huigang Chen & Christopher Otrok & Alessandro Rebucci & Eric R. Young, 2016. "Optimal Capital Controls and Real Exchange Rate Policies: A Pecuniary Externality Perspective," Journal of Monetary Economics, . citation courtesy of

The dangers of high capital flow volatility and sudden stops have led economists to promote the use of capital controls as an addition to monetary policy in emerging market economies. This paper studies the benefits of capital controls and monetary policy in an open economy with financial frictions, nominal rigidities, and sudden stops. We focus on a time-consistent policy equilibrium. We find that during a crisis, an optimal monetary policy should sharply diverge from price stability. Without commitment, policymakers will also tax capital inflows in a crisis. But this is not optimal from an ex-ante social welfare perspective. An outcome without capital inflow taxes, using optimal monetary policy alone to respond to crises, is superior in welfare terms, but not time-consistent. If policy c...