“Capital Controls and Financial Frictions in a Small Open Economy”

Shigeto Kitano, Kobe University

Kenya Takaku, Aichi Shukutoku University

 

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. The monotonic relationship between the degree of financial frictions and the welfare-improving effect of capital controls is robust for varying degrees of country premium, home bias in goods, and trade elasticity. Com- paring 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.”