Capital flow management when capital controls leak’, paper presented at

Abstract

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