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Capital Control, Exchange Rate Regime, and Monetary Policy: Indeterminacy and Bifurcation

William Barnett () and Jingxian Hu
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Jingxian Hu: Department of Economics, The University of Kansas;

No 201706, WORKING PAPERS SERIES IN THEORETICAL AND APPLIED ECONOMICS from University of Kansas, Department of Economics

Abstract: Will capital controls enhance macro economy stability? How will the results be influenced by the exchange rate regime and monetary policy reaction? Are the consequences of policy decisions involving capital controls easily predictable, or more complicated than may have been anticipated? We will answer the above questions by investigating the macroeconomic dynamics of a small open economy. In recent years, these matters have become particularly important to emerging market economies, which have often adopted capital controls. We especially investigate two dynamical characteristics: indeterminacy and bifurcation. Four cases are explored, based on different exchange rate regimes and monetary policy rules. With capital controls in place, we find that indeterminacy depends upon how inflation and output gap coordinate with each other in their feedback to interest rate setting in the Taylor rule. When forward-looking, both passive and positive monetary policy feedback can lead to indeterminacy. Compared with flexible exchange rates, fixed exchange rate regimes produce more complex indeterminacy conditions, depending upon the stickiness of prices and the elasticity of substitution between labor and consumption. We find Hopf bifurcation under capital control with fixed exchange rates and current-looking monetary policy. To determine empirical relevance, we test indeterminacy empirically using Bayesian estimation. Fixed exchange rate regimes with capital controls produce larger posterior probability of the indeterminate region than a flexible exchange rate regime. Fixed exchange rate regimes with current-looking monetary policy lead to several kinds of bifurcation under capital controls. We provide monetary policy suggestions on achieving macroeconomic stability through financial regulation.

Keywords: Capital controls; open economy monetary policy; exchange rate regimes; Bayesian methods; bifurcation; indeterminacy. (search for similar items in EconPapers)
JEL-codes: F41 F31 F38 E52 C11 C62 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-dge, nep-mac, nep-mon and nep-opm
Date: 2017-09, Revised 2017-09
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