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Capital Flows, Beliefs, and Capital Controls

Addressing policy-makers concerns that the post-GFC international capital flows to merging economies were speculative, we build a model with information frictions and use it to analyze different forms of capital controls. We show theoretically that survival forces proliferate in multi-good economies and that limiting financial trades offers welfare gains despite inhibiting insurance possibilities. Capital controls tame speculation motives, limit movements of the net foreign asset positions, and thus reduce consumption volatility. Our numerical analysis indicates that A) welfare gains from imposing capital controls can be substantial, equivalent to a permanent consumption increase of up to 4%, or 80 times the cost of business cycles. B) Controls that activate only during large inflows or outflows are preferred to those constantly active, e.g. a transaction tax used by some emerging market economies. C) Despite improving macroeconomic stability capital controls may unintentionally lead to increased volatility in the domestic financial markets.