Capital Flows, Beliefs, and Capital Controls
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Belief heterogeneity generates speculative cross-border capital flows
that are much larger than flows generated by the hedging/insurance
motives. We show theoretically that limiting financial trades may gen-
erate welfare gains despite inhibiting insurance possibilities. Financial
constraints tame speculation forces, limit movements of the net for-
eign wealth positions, and thus reduce consumption volatility. This
provides a novel justification for capital controls.
Simulations indicate that welfare gains from imposing capital con-
trols can be substantial, equivalent to a permanent consumption in-
crease of up to 4%, or 80 times the cost of business cycles. Controls
that activate only during substantial inflows or outflows are preferred
to those constantly active, e.g. a transaction tax used by some emerg-
ing market economies. Yet, despite improving macroeconomic stability
capital controls may unintentionally lead to increased volatility in the
domestic financial markets.