Capital Flows, Capital Controls, and Exchange Rate Policy

Many emerging market economies use alternative forms of capital controls. Often the use of capital controls is related to the defense of the exchange rate. This paper examines the welfare case for capital controls, and the interaction between capital controls and the exchange rate. The main question is whether capital controls may be justified, in order to gain independence in monetary policy, while at the same time pegging the exchange rate. Our results suggest a very conditional yes to this question, but only when there are capital outflows. Surprisingly, there is also a similar case for capital controls in face of capital inflows if the economy is on a freely floating exchange rate. But there are always better policies, which if available will eliminate the case for capital controls. As a corollary, our results suggest an optimal exchange rate stance for an economy experiencing capital flows; a country receiving capital inflows should follow a fixed exchange rate, while a country experiencing capital outflows should allow the exchange rate to float . * Devereux thanks SSHRC for financial assistance