Essays on Capital Flow Management

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This dissertation investigates two questions about capital flow management: first, how to manage capital flows when there is more than one market imperfection; second, whether capital flow restrictions lead to multilateral spillover effects.

In Chapter 2, I study the first question in a small open-economy DSGE model with two frictions: downward nominal wage rigidity and a price-dependent borrowing constraint. Wage rigidity introduces an aggregate demand externality under fixed exchange rates and the borrowing constraint introduces a pecuniary externality. I provide an analytical characterization of optimal capital flow management measures and show how they mitigate the externalities. Specifically, I find that the optimal policy in this economy is to restricts capital inflows when the risk of financial crisis is high or when wage is increasing, and to restrict capital outflows when unemployment is high and the risk of financial crisis is low. Using quantitative methods and standard calibration, I show that the optimal state-contingent capital inflow tax and even a non-state-contingent flat tax can significantly reduce unemployment and prevent financial crises, hence ultimately improving welfare. These results are of particular relevance for members of a currency union or emerging economies with an exchange rate peg.

I consider the second question in Chapter 3. In a simple model of capital flows and controls, I show that inflow restrictions distort international capital flows to other countries and that, in turn, such capital flow deflection may lead to a policy response. I then test the theory using data on inflow restrictions and gross capital inflows for a large sample of developing countries between 1995 and 2009. My estimation yields strong evidence that capital controls deflect capital flows to other countries with similar risk levels. Notwithstanding these strong cross-border spillover effects, I do not find evidence of a policy response.