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An Investigation in the Theory of Foreign Exchange Controls

A choice-theoretic, cash-in-advance model is constructed to examine foreign-exchange controls. While foreign-exchange controls improve the trade balance and the balance-of-payments (or exchange rate) they reduce welfare for a distortion-free, small, open economy. This is because foreign-exchange controls essentially place a quota on imports. Shocks to the terms-of-trade are shown to be transmitted negatively to the domestic economy when exchange controls are in effect. Devaluations are found not to have real effects. Finally, it is argued that foreign-exchange controls are not the optimal policy for attaining trade-balance objectives.