Question

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 foreign 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

Economists rarely agree and one point of contention has been whether or not a trade deficit, also known as a current account deficit, is a benefit or drawback to a country's economy. If a deficit is a net positive, how long a nation can thrive with such an imbalance is another sticking point.

A trade deficit can confer both positives and negatives for a country. It all depends on the circumstances of the country involved, the policy decisions that have been made and the duration and size of the deficit. Often times the observed data and the underlying economic theory don't line up.

Capital controls can reduce trade deficits but only at the expense of lower economic welfare. The effects of capital controls on trade imbalances can be analyzed by looking at how the effective gross rate of return changes in response to the shocks that generate trade imbalances. Basically, the level of capital controls governs how much ER is affected when there is a shock. In particular, the existence of trade costs and capital controls leads to the gap between borrowers and the lender’s ER, and the size of that gap is determined by their level. Given those shocks, regardless of how big trade costs or capital controls are, a net foreign asset borrower has a relatively higher ER than a lender. Lower trade costs or capital controls, however, make ER vary less across countries; a borrower and a lender would face relatively lower and higher ER compared with the case where trade costs and capital controls remain relatively high. Consequently, lower capital controls provide more incentives to borrow/lend, resulting in bigger trade imbalances.

Global trade imbalances have consistently increased over the last four decades, and it is important to understand what has contributed to this global phenomenon. One important limitation comes from the fact that comprehensive capital control measures are not available. Capital controls in this model are introduced in the form of a tax on the interest income from bonds, and thus the exogenous tax rates play an important role in quantifying the effects of lower capital controls on global imbalances. In particular, the tax rates are constructed based on the capital account openness index (Chinn-Ito index), and this index is too coarse to provide rich information on heterogeneity in each individual country’s capital control measures. A new dataset with finer granularity can help reconfirm the effects of capital controls and provide a more accurate quantification of it