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Capital Flow Management when Capital Controls Leak

date Date: June 1, 2014
date Author(s): Julien Bengui, Javier Bianchi
date Affiliation: University of Montreal-University of Wisconsin
Abstract

What are the implications of limited capital controls enforcement for the optimal
design of capital flow management policies? We address this question in an environment
where pecuniary externalities call for prudential capital controls, but financial
regulators lack the ability to enforce them in the “shadow economy.” While regulated
agents reduce their risk-taking decisions in response to capital controls, unregulated
agents respond by taking more risk, thereby undermining the effectiveness of the controls.
We characterize the choice of a planner who sets capital controls optimally,
taking into account the leakages arising from limited regulation enforcement. Our
findings indicate that leakages do not necessarily make macro-prudential policy less
desirable, and that stabilization gains remain large despite leakages. Finally, there can
be significant redistributive effects across the regulated and unregulated spheres.

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