Capital Flows, Capital Controls, and Exchange Rate Policy

Transcription

1 Capial Flows, Capial Conrols, and Exchange Rae Policy David Cook Hong Kong Universiy of Science and Technology Michael B. Devereux * Hong Kong Insiue of Moneary Research Universiy of Briish Columbia CEPR July 9, 200 Preliminary and Incomplee JEL Classificaion F40 F4 Absrac Many emerging marke economies use differen forms of capial conrols. Ofen he use of capial conrols is relaed o he defense of he exchange rae. This paper examines he welfare case for capial conrols, and he ineracion beween capial conrols and he exchange rae. The main quesion is wheher capial conrols may be jusified, in order o gain independence in moneary policy, while a he same ime pegging he exchange rae. Our resuls sugges a very condiional yes o his quesion, bu only when here are capial ouflows. Surprisingly, here is also a similar case for capial conrols in face of capial inflows if he economy is on a freely floaing exchange rae. Bu here are always beer policies, which if available will eliminae he case for capial conrols. As a corollary, our resuls sugges an opimal exchange rae sance for an economy experiencing capial flows; a counry receiving capial inflows should follow a fixed exchange rae, while a counry experiencing capial ouflows should allow he exchange rae o floa. * Devereux hanks SSHRC for financial assisance

2 Many counries, paricularly emerging marke economies, impose conrols on eiher inflows or ouflows of capial. The argumens for capial conrols are quie varied (Dooley 995), bu one cenral reason for capial conrols is ha hey allow a governmen o defend a fixed exchange rae while a he same ime giving some effeciveness o domesic moneary policy. In a much cied paper, Krugman (998) makes his case for he imposiion of capial conrols in he crisis-hi Eas Asian economies during he financial crisis in he region. This paper provides a heoreical analysis of he macroeconomic case for capial conrols. Specifically, we ask wheher he presence of price seing and nominal rigidiies in an open economy offers a case for capial conrols. Given ha a governmen may wish o defend an exchange rae, is here a welfare case for imposing capial conrols relaive o he alernaive opion of relinquishing domesic moneary policy independence? More generally, we ask wheher nominal rigidiies offer a case for capial conrols a all, even wihou he consrain of a fixed exchange rae. Our conclusions are quie novel. We do find a qualified case for capial conrols in an economy where he auhoriies remain commied o a fixed exchange rae. Bu his perains only o conrols on capial ouflows. There is no welfare case for capial inflow conrols o proec a fixed exchange rae. Moreover, perhaps surprisingly, we find a symmeric, qualified case for conrols on capial inflows when he economy is operaing under flexible exchange raes. The case for capial conrols arises because in a macro economy wih price sickiness here are generally wo disorions, or deviaions from efficiency. The firs is due o he monopolisic markup of price over marginal cos. The second is due o he sickiness of prices. Wha we show is ha capial conrols are only jusified when boh disorions are presen. Capial flows may end o exacerbae he monopolisic 2

3 disorion when here are sicky prices. For insance, capial ouflows under fixed exchange raes are associaed wih a decline in aggregae demand and a fall in oupu in he non-radable goods secor. Because, in our model, oupu in he non-radable secor is inefficienly low o begin wih, he degree o which capial inflows may exacerbae his under fixed exchange raes may acually decrease welfare. A similar case can be made for capial inflow conrols when he exchange rae is freely floaing. Bu he case for capial conrols from a macroeconomic welfare perspecive is limied because here is always a beer policy package, which if i could be employed, would eliminae he need for capial conrols. A combinaion of an opimal moneary rules and an employmen subsidy is shown o suppor a firs bes policy wihou he need for capial conrols. Bu even if a counry remains commied o a fixed exchange rae, an employmen subsidy alone also removes he case for capial conrols. A corollary of our resuls can also be obained. Assuming full capial mobiliy, we show ha here is an opimal exchange rae sance for an open economy experiencing capial flows. When he economy is subjec o capial inflows, i is beer o have a fixed exchange rae. When he economy is experiencing capial ouflows, i should follow a flexible exchange rae. Secion 2 lays ou he model. Secion 3 discusses calibraion and soluion. Secion 4 discusses he case for capial conrols and he impac of alernaive exchange rae policies. Secion 5 concludes. 3

4 Secion 2: The model We develop a model of a wo secor small economy. The economy produces boh radable and non-radable goods. Prices in he non-radable goods secor are prese by monopoliss. Households wish o consume a composie good ha is combined from radable and non-radable goods. 2. Preferences and budge consrains The represenaive agen ges uiliy from consumpion C, and disuiliy from ime spen working in he radables and non-radables, T H and NT H. Work in each secor is perfecly subsiuable, so ha oal work ime is H = H + H. We may wrie NT T he iner-emporal uiliy funcion as: E β ( U( C ) V( H )) 0 = 0 where U is increasing and concave, and V is increasing and convex. Aggregae consumpion is a linear homogenous funcion of consumpion of radable and nonradable goods: φ φ φ φ = + NT φ T ( ) ( ) ( ) C a C a C Where φ is he elasiciy of subsiuion beween radable and non-radable goods. The non-radable good is in urn defined over he consumpion of a coninuum of differeniaed goods, so ha. ρ ρ () NT C = x i di. 0 Sandard derivaions hen imply ha he consumer price index and he price index for non-radable goods are wrien respecively as: 4

5 NT T ( ) ( ) ( ) P = a P a P + ρ NT ρ () 0 NT P = P i di where NT P is he common price for all radable goods, and P ( i ) is he price of ype T i non-radable good. Each household faces he choice of purchasing curren consumpion goods, eiher radable or non-radable, working, and accumulaing domesic or foreign nominal bonds. The household earns income from wages, profis from he non-radable goods firms, and reurns on domesic and foreign bond holdings. The household s budge consrain is herefore wrien as: PC + B + S B = W H +Π + ( + i ) B + ( + i ) S B T, * * * where B represens he holding of foreign bonds, W is he nominal wage, S is he nominal exchange rae, and T is a governmen ax. 2.2 Household opimaliy condiions The household s opimal choice of bond holdings and labor supply resuls in he following firs order condiions: * S P + U'( C) = Eβ + i+ U'( C+ ) S P+ () ( ) P U'( C) = Eβ + i+ U'( C+ ) P + (2) ( ) W (3) U'( C) V '( H) P =. Finally, he individual demands for non-radable and radable goods are given as: φ T NT T P NT P () i C = ( a) C, C ( i) = a C. P P φ 5

6 2.3 Producion echnologies and profi maximizaion A perfecly compeiive indusry produces radable goods using he producion funcion: T T T Y F ( H ) =, T where F (.) is increasing and concave. The implici assumpion is ha here are specific facors, such as capial, ha are fixed wihin each secor. The non-radable firm i has he increasing and concave producion funcion given by: NT N N Y () i = F ( H ()) i. Compeiive profi maximizing firms in he raded goods secor implies he price is equal o marginal cos. T T T (4) PF '( H ) = W. In he non-radable secor, each producion firm has marke power, and ses he price as a markup over marginal cos. If non-radable goods prices were perfecly flexible, hen he profi maximizing decision for firm i would imply: NT N NT ρ (5) P () i F '( H ()) i = W, ρ where ρ ρ represens he monopoly markup. If non-radable prices canno adjus o shocks, hen (5) may no hold coninually. We discuss his furher below. 2.4 Moneary and fiscal policy We follow he recen lieraure (Woodford (999), Clarida e al (2000)) in absracing from he deails of he moneary mechanism, and simply assume ha he moneary auhoriy follows a domesic ineres rae argeing rule. We may define he domesic 6

7 nominal ineres rae as ( i ) U'( C ) P + β + + =. Then he moneary auhoriy is U'( C) P+ assumed o follow he rule: S (6) ( + i + ) =, ω > 0. β S0 ω The parameer ω represens he coefficien of exchange rae inervenion. So long as ω>0, here is a deerminae equilibrium value for he nominal exchange rae. The higher, is ω, he closer he moneary rule approximaes a pegged exchange rae, where he arge for he exchange rae peg is S 0. The fiscal auhoriy levies axes, issues bonds, and may offer employmen subsidies (see below). We assume ha he sock of governmen bonds ousanding is kep consan. Ineres paymens and subsidies are financed by he ax levy T. 2.4 Equilibrium An equilibrium of his economy is defined by he condiions resuling from household opimaliy, profi maximizaion, saisfacion of he moneary auhoriies budge consrain, and marke clearing condiions. Since non-radable goods mus be boh produced and consumed only in he domesic economy, he marke clearing condiion in he non-radable secor is wrien as (since all non-radable firms are alike, we drop he firm specific subscrip hereafer): (7) Y NT = C. NT Combining his wih he households budge consrain, his implies ha he economies exernal balance of paymens relaionship is (8) P B = ( + i ) B + + ( C Y ). T * * * T T S 7

8 Finally, we assume ha he radable goods price obeys he `law of one price condiion (9) P T = S, where he foreign currency price of he radable good is normalized o uniy. Secion 3. Capial flows and welfare 3. Perfec foresigh equilibrium Firs ake a perfec foresigh equilibrium where agens have full knowledge of he pah of he money supply and foreign ineres raes from dae zero. In addiion, assume ha he foreign ineres rae is consan, and equal o he domesic rae of ime preference, so ha * β ( + i ) =. Then if he economy sars ou wih a zero ne foreign asse posiion, i is easy o esablish ha a seady sae equilibrium is aained a dae zero, where he curren accoun is zero, and consumpion and oupu are consan over ime. This equilibrium may be described by he following condiions, NT T N which give he four equilibrium values of H, H, p, C N NT NT p (9) F ( H ) = a C N Γ( p ) φ (0) T T F ( H ) = ( a) C N Γ( p ) ρ T T N N NT () F '( H ) = p F '( H ) ρ (2) T ' T F ( H ) NT T U'( C) = V '( H + H ) N Γ( p ) where N( φ ) φ Γ ( p N ) = ap + ( a), and p N NT = P. From he soluions given by S his sysem, we may recover all oher variables. 8

9 3.2 Moneary policy The equilibrium depends on he sance of moneary policy. If all prices are perfecly flexible, hen moneary policy deermines only he level of domesic prices and he domesic nominal ineres rae. If however, he non-raded goods prices is pre-se, hen he moneary policy rule is imporan for he pah of real variables in he economy, following an unanicipaed shock. The sance of moneary policy is deermined by he single parameer ω Ineres rae shocks Our objecive is o ask wheher from a welfare perspecive, i may be warraned for he auhoriies of he small economy o limi foreign capial inflows (ne borrowing) or ouflows (ne lending). To analyze he effecs of capial flows in a simple way, we conduc he following simple experimen. Le he foreign ineres rae unexpecedly rise above (fall below) he domesic rae of ime preference for period zero * β ( + i ) > ( β ( + i ) < ). Following his, he foreign ineres rae reurns back o he * domesic rae of ime preference, so ha β + = for all >. If he economy * ( i ) sars ou in he seady sae posiion described in he previous paragraph, hen he appendix shows ha his perurbaion in he foreign ineres rae will generae a period zero curren accoun surplus (defici) if he foreign ineres rae rises above (falls below) he domesic rae of ime preference. Following his however, in period and for all fuure periods, he curren accoun will be zero, and consumpion, labor supply, and he relaive price of non-radable goods will be consan. The effec of his shock will depend criically on wheher prices can respond immediaely or no. We firs illusrae he impac when all prices can respond. Bu he cenral resuls perain o he case where he non-radable goods prices canno adjus a he ime of he ineres rae shock. 9

10 3.4 Calibraion In general here is no closed form soluion o his model, excep in he seady sae, wihou capial flows. In order o obain resuls, we calibrae he model, and obain he soluion numerically. In order o calibrae, we make he following assumpions wih respec o funcional forms. Le he uiliy funcion be: ( σ ) C η H σ + ψ + ψ. The parameer σ represens he iner-emporal elasiciy of subsiuion, and ψ represens he inverse of he elasiciy of labour supply. In addiion, he producion funcions for raded and non-raded goods respecively are: T T NT γ NT NT NT α F = A ( H ), F = A ( H ) α <, γ <. Table repors he baseline calibraion assumpions. We follow he open economy macro lieraure in picking parameer values. The iner-emporal elasiciy of subsiuion is se a 2, following Backus, Kydland and Kehoe (995). The rae of ime preference is se a 0.05, so he subjecive discoun facor is The value of η is unimporan for welfare resuls, jus deermining scale, so we se i arbirarily o uniy. The share of non-raded goods in he consumer price index is se a 0.5, following he evidence cied in Schmi and Uribe (2000) for Mexico and Cook and Devereux (200) for Malaysia and Thailand. The elasiciy of labour supply is se o 0.5, so ha ψ = 2. This is roughly in he middle of he various esimaes of labor supply in he lieraure, based on micro evidence and aggregae macro daa (reference?). The elasiciy of subsiuion beween non-raded and raded goods is se a.5. This accords wih he assumpions made in Backus Kydland and Kehoe (995) over he elasiciy of subsiuion beween home and foreign goods. The elasiciy of subsiuion beween varieies of non-radable goods is ρ, and his 0

11 governs he equilibrium markup of price over cos in he non-raded good secor. We assume ha his markup is 20 percen. This is slighly higher han he common value of 0 percen (e.g. Basu and Fernald 997) used for inernaional macro sudies of he indusrial economies, bu i is likely ha markups are higher in emerging markes. We assume ha non-raded goods producion is relaively labour inensive, wih α = 0.7, and raded goods is relaively non-labour inensive, wih γ = 0.3. Evidence of his from Eas Asian daa is presened in Cook and Devereux (200). Finally, we vary he ineres rae adjusmen parameer ω, beween 0.0, which represens a case where he moneary auhoriy is conen o allow significan adjusmen in he nominal exchange rae, and 9000, represening a case where he moneary auhoriy essenially keeps he exchange rae pegged. In addiion, in he analysis below we examine an opimal moneary rule ha lies beween hese wo values. Table : Baseline Calibraion Variable Value Variable Value σ 2 φ.5 β ρ 6 η α 0.7 a 0.5 γ 0.3 ψ 2 ω 0.0, 9000 Secion 4. The impac of capial flows 4. Welfare evaluaion We now examine he impac of changes in he res of he world ineres rae (as defined in secion 3.3 above) on he curren accoun, he real exchange rae, oupu

12 and welfare in he domesic economy. As noed above, he saring poin is assumed o be he economy in iniial seady sae wih zero ne deb, defined by he sysem (9)- (2). Given he calibraion se ou in Table, a value of he world ineres rae of 0.05 produces his seady sae. We define he firs period curren accoun as * B, he real exchange rae as P P NT (he relaive price of non-raded goods in erms of he domesic CPI), and oupu is defined as he CPI deflaed sum of producion in he non-raded and raded goods secor: p F ( H ) + F ( H ). N NT NT T T N Γ( p ) The impac of an ineres rae change is examined under wo alernaive pricing regimes. In he firs regime, i is assumed ha he non-raded goods price can adjus immediaely so as o ensure ha he condiion (5) holds a all imes. In he second regime, i is assumed ha he non-raded goods price is sicky (a he level implied by he original equilibrium wih i * = 0.05 ), and akes one period o fully adjus o he ineres rae shock. Since he fuure pah of he ineres rae afer ime period = is known, by assumpion, he non-raded goods price will adjus o is new seady sae level a ime = Capial flows wih fixed exchange raes The flexible price case Figure illusraes he impac of variaions in he ineres rae on he period levels of oupu, he real exchange rae, he curren accoun, and overall lifeime welfare. This Figure perains o he case ω = 9000, so he exchange rae is held fixed. Boh he flexible price and case where he price of he non-raded good is sicky for he firs 2

13 period is illusraed. Since he impac of ineres rae changes is symmeric, we discuss only he effecs of an foreign ineres rae increase. Figure a shows ha beginning a curren accoun balance, a emporary ineres rae increase will raise GDP in he flexible price case. The rise in he ineres rae will cause a fall in curren consumpion and a rise in fuure consumpion, causing a rise in curren labour supply and oupu. Bu he rise in he ineres rae simulaneously generaes a real exchange rae depreciaion (Figure b), as he fall in consumpion reduces he curren demand for non-raded goods. Figure e and f shows he breakdown of he response of overall oupu beween he wo secors. Non-raded oupu is subjec o conflicing effecs. Consumpion falls, reducing demand for nonradable goods, bu hen he real exchange rae depreciaion generaes a counerbalancing increase in demand for non-radable goods. Wih flexible prices, hese hings counerbalance each oher, and non-radable goods oupu is essenially consan. Traded good oupu rises, as he fall in he real wage simulaes higher employmen in ha secor. From Figure d, we hen see ha lifeime welfare rises in response o he emporary rise in he foreign ineres rae. Noe ha he Figure d illusraes ha welfare rises for any foreign ineres rae change, wheher i is a rise or a fall. This is o be expeced. When he non-raded goods price can adjus immediaely, he small * economy gains from capial markes, wheher here is a capial ouflow ( β ( + i ) > ) * or a capial inflow ( β ( + i ) < ). A key elemen of he adjusmen process, illusraed in Figure b and g, is ha he real exchange rae depreciaion cushions he full impac of he rise in world real ineres raes on consumpion. The firs period depreciaion leads o a rise in he 3

14 effecive domesic real ineres rae defined as ( + i ) S P, ha is less han he rise * 2 S P2 in he world ineres rae, ( + i ). * The fixed price case Now le us examine he case where he non-raded good price canno adjus o he ineres rae change. In his case Figure a illusraes ha domesic GDP falls as he ineres rae rises. Again, he rise in he ineres rae will cause a fall in curren consumpion, and a rise in labour supply. Bu wih he non-raded good price emporarily sicky, he lower domesic wage has no affec on oupu in his secor, and insead oupu falls due o he fall in domesic demand. Figure b shows ha he real exchange rae is unalered by he ineres rae increase, as boh he nominal exchange rae and he non-radable good price are fixed. The absence of real exchange rae depreciaion has wo effecs. Firs, i leads o a greaer fall in he demand for nonradable goods han in he flexible price case, and i leads o a greaer fall in consumpion han in he flexible price case (Figure g). This means ha non-radable goods producion (Figure e) falls significanly more in he presence of sicky prices. On he oher hand, he radable good secor expands by more, due of he greaer fall in he equilibrium wage rae wih fixed exchange raes and sicky prices. Figure d shows ha welfare falls in response o a rise in he ineres rae in he fixed price economy. On he oher hand, welfare rises when here is a fall in he ineres rae. Condiional on he pre-se price of he non-radable, welfare is acually higher in his case han in he flexible price economy when he ineres rae falls. Numerous sensiiviy experimens indicae ha his resul is quie general. In he presence of price sickiness in he non-radable goods secor, and fixed exchange raes, capial * ouflows (he case β ( + i ) > ) end o reduce welfare, while capial inflows (he 4

15 * case β ( + i ) < ) end o raise welfare. The essenial inuiion behind his finding is linked o he presence of he monopolisic disorion in price seing. We discuss his furher below. 4.3 Capial flows wih flexible exchange raes Now we assume ha exchange raes are flexible. We se ω = 0.0 in he ineres rae rule above. Figure 2 illusraes he impac of ineres rae changes in his case. The resuls for he flexible price economy are he same as in Figure. Bu wih fixed prices, he resuls are quie differen. The flexible exchange rae rule leads GDP o rise in response o a rise in he foreign ineres rae, and oupu rises by even more han in he flexible price economy. The explanaion can be seen by looking a Figure 2b and 2g. The rise in he ineres rae generaes a real exchange rae depreciaion. The depreciaion exceeds ha of he flexible price economy. This acs so as o reduce he effecive real ineres rae relaive o ha of he flexible price economy, and so herefore curren aggregae consumpion falls by less. The combinaion of a smaller drop in consumpion and a larger real exchange rae appreciaion leads o a rise in oupu of he non-radable secor, while he same facors lead o a level of radable good oupu ha is essenially unchanged. As before, he rise in he foreign ineres rae leads o a domesic curren accoun surplus. Figure 2d illusraes he welfare resuls. Wih flexible exchange raes, welfare rises in response o an ineres rae increase, by more han i would if non-raded goods prices were flexible. A he same ime, welfare falls in response o a fall in he world ineres rae. Therefore, in uiliy erms, he economy under a flexible exchange rae has precisely he opposie implicaions o ha under fixed exchange raes. Capial inflows end o reduce welfare, while capial ouflows end o increase welfare. 5

16 4.4 The role of pricing disorions Sandard resuls from inernaional macro heory would sugges ha a counry gains from inernaional capial inflows and ouflows. We see ha hese gains are realized when non-radable prices are flexible. Bu in he presence of price sickiness, capial ouflows generae losses under a pegged exchange rae, while capial inflows incur welfare losses under a flexible exchange rae (when capial flows are generaed by ineres rae differenials beween he home and he foreign counry). Wha is he explanaion behind hese findings? The imporan feaure of he economy is ha he monopolisic pricing disorions lead o an inefficienly low level of oupu in he nonradable good secor. This is a feaure of he economy wih or wihou price sickiness. Bu he combinaion of capial flows and sicky prices ends o exacerbae his inefficiency. In he iniial equilibrium, when * β ( + i ) =, he wo alernaive moneary policies lead o he same oucome, as prices are se a he opimal level. Bu when here is an unanicipaed rise in he foreign ineres rae, and he exchange rae is pegged, here is a fall in non-radable oupu, and hus oupu in his secor moves furher away from is efficien level. This causes overall welfare o fall. Similarly, wih a flexible exchange rae, a fall in he world ineres rae causes a big real appreciaion, and a fall in non-radable oupu, again pushing i furher away from is efficien level. The same argumen works in reverse when he ineres rae falls under a pegged exchange rae, or rises under a flexible exchange. In boh cases, nonradable oupu increases, and he economy is pushed more owards is efficien level. 6

17 4.5 A case for capial conrols? Should capial flows be prevened? Our resuls indicae ha capial ouflows under pegged exchange raes (or capial inflows under flexible exchange raes) may be welfare reducing. A a superficial level, i migh seem ha his gives a case for imposing conrols on capial ouflows or inflows. In paricular, i could be used o raionalize a policy of conrolling capial ouflows when he economy is consrained (perhaps for poliical reasons) o follow a fixed exchange rae. Figure 3 illusraes he implicaions of capial ouflow conrols in he case of a pegged exchange rae. A capial ouflow conrol is assumed here o work perfecly and o be dependen on he foreign ineres rae. Assume ha he moneary auhoriy ses a ax on he foreign ineres earnings, so ha he domesic nominal ineres rae is * ( i) ( i )( ) + = +, where * i i =. This policy adjuss he domesic ineres rae so as o offse he effec + i of he foreign ineres rae change. I implies ha a rise in he foreign ineres rae has no affec on he curren accoun, he real exchange rae, oupu or welfare a all. Thus, compared o he effecs of a rise in he foreign ineres rae under fixed exchange rae wihou a capial ouflow, his policy does beer in welfare erms. There is an equivalen policy for he case of a fall in he foreign ineres rae under flexible exchange raes. Bu while capial conrols may raise welfare relaive o a siuaion of unresriced capial flows, hey are hemselves inferior o a number of alernaive policies. One clear alernaive is a subsidy on he producion of non-radable goods (an employmen subsidy given o non-radable goods producers). If non-radable goods producers are 7

18 offered a subsidy equal o s, hen he effecive wage facing non-radable producer s is W( s). A value of s = offses he monopolisic disorion. Figure 4 ρ illusraes he welfare effecs of ineres rae changes in he fixed exchange rae economy, when an employmen subsidy in he non-radable good secor is uilized (he qualiaive impacs on all oher variables is he same as in Figure ). We see ha he perverse welfare response of an ineres rae increase is eliminaed. Welfare rises now, wheher he ineres rae rises or falls. The sandard gains from inernaional capial flows are resored. Noe ha, due o he sicky price in he non-radable good secor, welfare is sill lower han under flexible prices everywhere excep a he poin * where he non-raded good price is a he opimal level ( β ( + i ) = ). Neverheless, when he underlying monopolisic disorion is eliminaed direcly by fiscal policy, he case for capial conrols is eliminaed. Do capial conrols allow an independen moneary policy? A common argumen in he discussion of inernaional macroeconomic policy is ha capial conrols may be used o allow for an independen moneary policy while sill mainaining a fixed exchange rae. From he las paragraph, Figure 3 gives an example of his. A ax on foreign lending ha varies wih he difference beween he domesic and foreign ineres rae allows he economy o keep i domesic real ineres rae consan, despie having a fixed exchange rae. Thus moneary policy independence is obained by use of capial conrols. Bu despie his, i would be beer for he economy o use an acive moneary policy rule ha allows for exchange rae adjusmen. From he resuls of Figure and Figure 2, we migh guess ha here was an inermediae value of ω which did beer in welfare erms han eiher a fixed exchange rae or a flexible exchange rae. From our 8

19 baseline model, we find ha he value ω. leads he economy wih sicky prices o replicae ha flexible price economy, in response o flucuaions in he foreign ineres rae. Thus, in erms of Figure, loci for he flexible and fixed price economies would overlap when moneary policy is adjused opimally in his way. Inuiively, an opimal moneary policy rule ensures ha all real exchange rae adjusmen is accomplished hrough nominal exchange rae adjusmen, so ha he non-radable good price would no change in response o changes in he foreign ineres rae, even in he flexible price economy. This herefore eliminaes he real consequences of nominal price sickiness. From his perspecive, we see ha an opimal moneary policy rule always dominaes a policy of capial conrols. A mos, capial conrols can preven movemens in foreign ineres raes from causing welfare losses. Bu if moneary policy is used opimally, hen he economy can exploi changes in he foreign ineres rae o obain welfare gains. Finally, alhough an opimal moneary rule can cause he economy wih sicky prices o mimic he flexible price economy, here is sill a monopolisic pricing disorion. A joinly opimal fiscal and moneary rule (a firs bes rule) would combine he employmen subsidy o non-radable producers wih an opimal moneary rule. Bu capial conrols are no a componen of his opimal policy package. 4.6 Exchange rae policies and capial flows The model also has implicaions regarding he appropriae exchange rae policies o deal wih capial flows. I has been quie widely observed ha emerging marke economies ofen ry o keep heir exchange rae fixed in face of srong capial inflows. Someimes his is raionalized by he argumen ha he auhoriies wish o preven excessive real exchange rae appreciaion. Alhough our model can only parially 9

20 capure he se of issues relaed o capial flows in emerging markes, i does provide a welfare-based explanaion of why an emerging economy would like o keep is exchange rae fixed in face of capial inflows. Take Figures and 2 again, and imagine ha hey deal wih he siuaion of an emerging marke economy opening up is capial marke o he ouside world. If he res of he world s ineres rae is lower han he domesic rae of reurn, hen he counry will receive capial inflows. If in addiion, he adjusmen process is characerized by price rigidiies in he non-raded goods secor, hen Figures and 2 indicae ha he auhoriies are beer off o keep he exchange rae fixed in face of he capial inflow. By fixing he exchange rae, hey can preven excessive real exchange rae appreciaion ha would occur under a fully flexible exchange rae. Under a fixed exchange rae, he economy gains from capial inflows, whereas i would lose under a flexible exchange rae. The siuaion is reversed when he capial marke liberalizaion leads o capial ouflows. Using he same logic, he counry would be beer off o allow he exchange o floa. By doing so, i would faciliae he necessary real exchange rae depreciaion, ensuring ha capial ouflows raise welfare. A fixed exchange rae, by conras, would preven real depreciaion, and he capial inflows would reduce welfare. Of course, in boh cases, i is imporan o qualify he argumen by saing ha he bes policy, if i was available, would sill be o eliminae he pricing disorion and use he opimal moneary rule. Secion 5. Conclusions This paper has provided a welfare-based analysis of he policy rade off beween independen moneary policy, exchange rae sabiliy, and capial mobiliy. A cenral quesion was wheher i made sense o employ capial conrols o give some moneary freedom under he consrain of a fixed exchange rae. We found a limied case 20

21 argumen for capial conrols in his conex, if conrols are designed o preven capial ouflows. Bu here are always beer policies available, even in he presence of he exchange rae consrain. Moreover, surprisingly, we find ha here is a symmeric argumen for inflow conrols under floaing exchange raes. Finally, he model suggess ha he appropriae exchange rae policy for capial inflows may be differen han ha for capial ouflows. Of course, here may be oher reasons o use capial conrols ha are no analyzed here. For insance, capial conrols migh be used o reduce he risk of financial crises by alering he mauriy srucure of deb, as in he Chilean experimen (see Edwards). Neverheless, a leas some of he impeus for capial conrols comes from is abiliy o gain independence in macroeconomic policy under a fixed exchange rae (e.g. Krugman 998). Our resuls sugges ha he case for his is quie limied. 2

22 References Backus, D. P. Kehoe, and F. Kydland (995) Inernaional Real Business Cycles: Theory and Evidence, in T.F. Cooley ed. Froniers of Business Cycle Research, Princeon Universiy Press. Clarida, Richard, Jordi Gali and Mark Gerler (999), The Science of Moneary Policy: A New Keynesian Perspecive, Journal of Economic Lieraure 37, Cook, David and Michael B. Devereux (200), The Macroeconomics of Inernaional Financial Panics, mimeo UBC. (200) The Malaysian Capial Conrols: Effeciveness and Side Effecs, mimeo, HKUST Dooley, Michael (995) A Survey of Academic Lieraure on Conrols over Inernaional Capial Transacions, NBER d.p Krugman, Paul (998), Asia: ime o ge radical, Forune Magazine Sockman, Alan and Linda Tesar (995), Tases and Technology in a Two Counry Model of he Business Cycle, American Economic Review 85, Woodford, Michael (999), Ineres and Prices, manuscrip, Princeon Universiy. 22

23 Figure a Oupu b Real Exchange Rae Fixed Exchange Rae Flexible Price ROW ineres rae ROW ineres rae Figure c: Curren Accoun/GDP d: Welfare ROW ineres rae ROW ineres rae 23

24 e: NT Oupu Figure f: T Oupu ROW ineres rae ROW ineres rae Figure g: Consumpion ROW ineres rae 24

25 2a: Oupu Figure 2b: Real Exchange Rae Flexible Price Flexible Exchange Rae ROW ineres rae ROW ineres rae Figure 2c: Curren Accoun/GDP 2d: Welfare ROW ineres rae ROW ineres rae 25

26 Figure 2e: NT Oupu Figure 2f: T Oupu ROW ineres rae ROW ineres rae Figure 2g: Consumpion ROW ineres rae 26

27 Figure 3a: Oupu Figure 3b: Real Exchange Rae Fixed Exchange Rae (Capial Conrols) Flexible Price ROW ineres rae ROW ineres rae Figure 3c: Curren Accoun/GDP Figure 3d: Welfare ROW ineres rae ROW ineres rae 27

28 Figure 3e: NT Oupu Figure 3f: T Oupu ROW ineres rae ROW ineres rae Figure 3g: Consumpion ROW ineres rae Figure 4: Welfare Flexible Price Fixed Exchange Rae (Employmen Subsidy) ROW ineres rae 28