Essays of the Effectiveness of Capital Controls

Financial globalization paired with the evident volatility of capital flows has sparked renewed interest in capital account restrictions on both inflows and outflows. This dissertation, composed of three essays, analyzes the effectiveness of these policy tools. The first chapter studies the effectiveness of capital inflow controls in insulating countries from foreign interest rate shocks. This chapter estimates a standard VAR augmented to include a capital inflow control index. To examine the systematic effect of capital controls on the economy, counterfactual VARs are constructed by 'zeroing out' capital controls and their effects in the VAR system. Target-variable impulse responses are compared between the factual and counterfactual scenarios. The essay finds that capital controls are statistically and economically significant in protecting the domestic tradable sector from foreign interest-rate shocks for countries with a managed exchange rate regime.

The second chapter of this thesis presents a small-open-economy DSGE model that incorporates a learning-by-doing externality in the tradable sector. In the model, capital controls are the endogenous response of a benevolent government. The impulse responses generated by the theory model qualitatively match those from the empirical section in the first chapter.

Finally, the third essay, is an empirical analysis of the effects of unanticipated changes in capital outflow-controls in a sample of 31 countries during 1995-2010. Using as the yardstick of effectiveness the impact of changes in outflow-controls on net capital flows, this chapter finds that in countries with strong macroeconomic positions, a tightening of outflow-controls did help reduce net outflows, and a relaxation helped reduce net inflows. Furthermore, the chapter finds that innovations to capital controls are very important in explaining movements in net inflows.