Dilemma not Trilemma? Capital Controls and Exchange Rates with Volatile Capital Flows

Emmanuel Farhi and Iván Werning

Working Paper from Harvard University OpenScholar

Abstract: We consider a standard New Keynesian model of a small open economy with nominal rigidities and study optimal capital controls. Consistent with the Mundellian view, we find that the exchange rate regime is key. However, in contrast with the Mundellian view, we find that capital controls are desirable even when the exchange rate is flexible. Optimal capital controls lean against the wind and help smooth out capital flows.

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