International Macroeconomics, Chapter 3 81

Clearly, in period 1 consumption falls and both the trade balance and the

current account improve. Note that the decline in consumption in period 1 is

independent of whether the country is a net foreign borrower or a net foreign

lender in period 1. This is because for the particular preference specification

considered in this example, the substitution effect always dominates the

income effect.

3.6 Capital Controls

Current account deficits are often viewed as bad for a country. The idea

behind this view is that by running a current account deficit the economy

is living beyond its means. As a result, the argument goes, as the country

accumulates external debt, it imposes future economic hardship on itself in

the form of reduced consumption and investment spending when the foreign

debt becomes due. A policy recommendation frequently offered to coun-

tries undergoing external imbalances is the imposition of capital controls.

In their most severe form, capital controls consist in the prohibition of bor-

rowing from the rest of the world. Milder versions take the form of taxes on

international capital inflows.

We can use the model economy developed in this chapter to study the

welfare consequences of prohibiting international borrowing. Suppose that

the equilibrium under free capital mobility is as depicted in figure 3.8. The

optimal consumption basket is given by point B and the endowment bundle

is represented by point A. The figure is drawn under the assumption that

the economy starts period 1 with a nil asset position (B0∗ = 0). In the uncon-
82 S. Schmitt-Grohé and M. Uribe

Figure 3.8: Equilibrium under capital controls

C2

slope = − (1+r*)

Q2 A

B
slope = − (1+r1) →

Q1 C1

strained equilibrium, households optimally choose to borrow from the rest of

the world in period 1 in order to finance a level of consumption that exceeds

their period-1 endowment. As a result, in period 1 the trade balance (T B1 ),

the current account (CA1 ), and the net foreign asset position (B1∗ ) are all

negative. In period 2, consumption must fall short of period-2 endowment

to allow for the repayment of the debt contracted in period 1 plus the corre-

sponding interest. Assume now that the government prohibits international

borrowing. That is, the policymaker imposes financial restrictions under

which B1∗ must be greater than or equal to zero. Agents cannot borrow

from the rest of the world in period 1, therefore their consumption can be

at most as large as their endowment. It is clear from figure 3.8 that any

point on the intertemporal budget constraint containing less period-1 con-

International Macroeconomics, Chapter 3 83

sumption than at point A (i.e., any point on the budget constraint located

northwest of A) is less preferred than point A. This means that when the

capital controls are imposed, households choose point A, and the borrowing

constraint is binding. In the constrained equilibrium we have that B1∗ = 0

and C1 = Q1 . The fact that consumption equals the endowment implies that

the trade balance in period 1 is zero (T B1 = Q1 − C1 l = 0). Further, given

our assumption that the initial net foreign asset position is zero (B0∗ = 0),

the current account in period 1 is also nil (CA1 = T B1 + r0 B ∗ 0 = 0). This

in turn implies that the country starts period 2 with zero external debt

(B1∗ = B0∗ + CA1 = 0). As a consequence, the country can sepnd its entire

period-2 endowment in consumption (C2 = Q2 ).

The capital controls are successful in achieving the government’s goal

of curbing current-account deficits and allowing for higher future spending.

But do capital controls make households happier? To answer this question,

note that the indifference curve that passes through the endowment point

A, the consumption bundle under capital controls, lies southwest of the

indifference curve that passes through point B, the optimal consumption

bundle under free capital mobility. Therefore, capital controls lower the

level of utility, or welfare.

Under capital controls the domestic interest rate r1 is no longer equal to

the world interest rate r ∗ . At the world interest rate, domestic households

would like to borrow from foreign lenders in order to spend beyond their

endowments. But capital controls make international funds unavailable.

Thus, the domestic interest rate must rise above the world interest rate to

bring about equilibrium in the domestic financial market. Graphically, 1+r1

84 S. Schmitt-Grohé and M. Uribe

is given by the negative of the slope of the indifference curve at point A.

The slope at this point is given by the slope of the dashed line in figure 3.8.

Only at that interest rate are households willing to consume exactly their

endowment. Formally, the domestic interest rate under capital controls is

the solution to the following expression:

U1 (Q1 , Q2 ) = (1 + r1 )U2 (Q1 , Q2 ).

This expression is the household’s optimality condition for the allocation

of consumption over time, evaluated at the endowment point. Notice that

because Q1 and Q2 are exogenously given, the above expression represents

one equation in one unknown, r1 . The smaller is Q1 relative to Q2 , the

higher will be the marginal utility of consumption today relative to the

marginal utility of consumption next period, and therefore the higher will

be the interest rate. Intuitively, the lower is output in period 1 relative to

output period 2, all other things equal, the larger will be the desire to borrow

in period 1. To dissuade agents from borrowing in period 1, the domestic

interest rate must rise.