Title

Capital Controls and Financial Frictions in a Small Open Economy

Abstract

We develop a small open economy model with financial frictions between domestic banks and foreign investors, and examine the welfare-improving effect of capital controls. We show that capital controls are effective in addressing the amplification effect due to financial frictions. As the degree of financial frictions increases, the welfare-improving effect of capital controls becomes larger and a more aggressive policy rule is appropriate. Comparing two economies, one with and one without "liability dollarization," we also find that the welfare-improving effect of capital controls is larger in the presence of "liability dollarization," and the difference between the effects becomes larger as the degree of financial frictions increases.

Keywords

Capital control, Financial frictions, Financial intermediaries, Balance sheets, Small open economy, Liability dollarization, DSGE, Welfare

JEL Classification

E69, F32, F38, F41

Inquiries

Shigeto KITANO
Research Institute for Economics and Business Administration
Kobe University
Rokkodai-cho, Nada-ku, Kobe
657-8501 Japan
Phone: +81-78-803-7036
FAX: +81-78-803-7059

Kenya TAKAKU
Faculty of International Studies, Hiroshima City University