Question

ercise 5.8: Consider a parameter configuration such that a small open economy is currently running a trade balance deficit. Many governments have in the past implemented capital controls, for example, a legal restriction that prevent for- eign agents from purchasing domestic financial assets. Presumably, the idea here is that a trade balance deficit is a bad thing,' and that the capital controls will serve to prevent an 'excessive deficit from occurring. Use the theory developed here to show that while capital controls can successfully reduce (or eliminate) a trade deficit, this is likely to come at the expense of lower economic welfare for domestic agents.

Answer 1

Capital controls can successfully reduce a trade deficit:

a) Methods which are to be taken to lower the trade deficit:

• Lowering foreign direct investment in the domestic economy
• Lowering foreign institutional investment in the domestic economy
• Reducing external commercial borrowing which includes NRI deposits, banking capital, short term trade credits, other flows

b) By taking the following methods, capital will be controlled in order to check the trade deficit.

c) Trade deficit occurs when: Import of material goods> export of material goods.

It can also be corrected by depreciating the exchange rate and imposing tax on capital inflows.