3.

6 Capital Controls

• Section 3.6 uses the two-period endowment model to analyze the effects of capital
controls that prohibit international borrowing. The motivation is that current account
deficits are often viewed negatively as "living beyond one's means", so policymakers
sometimes impose controls to curb external borrowing.
• The analysis considers the equilibrium under free capital
mobility, depicted in Figure 3.8. The optimal consumption
point is B, which lies to the southeast of the endowment point
A. This implies the household borrows from abroad in period
1 to finance consumption exceeding its period 1 endowment
(Q1). As a result, the trade balance (TB1), current account
(CA1), and net foreign asset position (B1) are all negative in
period 1.
• In period 2, consumption has to fall below the endowment Q2
to repay the debt plus interest incurred in period 1.The
household chooses to borrow in period 1 because it prefers to
smooth consumption over time given its endowment stream
and interest rates.
 3.6 Capital Controls

• Now consider the imposition of capital controls that prohibit international borrowing, so B1
≥ 0. This constraints the household to choose a point on the budget constraint northwest of
A, as any point southeast of A involves borrowing. The household will choose the
endowment point A in this case. At A, consumption equals the endowment in each period
(C1 = Q1, C2 = Q2). This means the trade balance is zero in both periods. And since the initial
net foreign assets B0 = 0, the current account is also zero in each period.

• So the capital controls are successful in preventing current account deficits in period 1.
However, the household is forced to consume its endowment stream without the ability to
smooth consumption over time.

• This loss of consumption smoothing makes the household worse off in welfare terms. The
indifference curve passing through the optimal point B under free mobility lies strictly
northwest of the indifference curve through the capital control point A. So imposing controls
lowers utility.
 3.6 Capital Controls

• Graphically, the domestic interest rate r1 under controls exceeds the world rate r* and is
given by the slope of the dashed line at point A. This higher interest rate is needed to
discourage households from borrowing when capital inflows are prohibited.

• Formally, r1 under controls solves: U1(Q1, Q2) = (1+r1)U2(Q1, Q2), which states that at the
endowment levels, the marginal utilities from periods 1 and 2 consumption must be set
equal by the domestic interest rate. This ensures households are willing to simply consume
their endowments in each period.

• Intuitively, the more heavily skewed the endowment is towards period 2 (Q2 much larger
than Q1), the higher r1 must be to offset households' desire to borrow from the future to
raise period 1 consumption.
 3.6 Capital Controls

• In summary, while capital controls can reduce or eliminate current account

deficits in the short run, the model shows they come at a welfare cost by
preventing consumption smoothing over time. Households prefer the ability to
borrow in some periods and lend in others to optimally distribute consumption
across periods given their income stream.
• The results caution against simply viewing current account deficits as
universally bad - they may reflect the optimal smoothing of consumption for
forward-looking households responding to temporary income fluctuations.
Policies like capital controls that prevent this smoothing can impose welfare
costs, even if successfully reducing deficits.