Optimal capital controls and real exchange rate policies: A pecuniary externality perspective

A new literature studies the use of capital controls to prevent financial crises. Within this new framework, we show that when exchange rate policy is costless, there is no need for capital controls. However, if exchange rate policy entails efficiency costs, capital controls become part of the optimal policy mix. When exchange rate policy is costly, the optimal mix combines prudential capital controls in tranquil times with policies that limit exchange rate depreciation in crisis times. The optimal mix yields more borrowing, fewer and less severe financial crises, and much higher welfare than with capital controls alone. (C) 2016 Elsevier B.V. All rights reserved.