Models of Balance of Payments Crises with Capital Controls
Abstract: We examine techniques to delay the collapse of unsustainable fixed exchange rates caused by excessive domestic credit growth. Capital controls, combined with free trade, postpone the collapse, resulting in a trade deficit and consumption boom. Real interest rates rise above international levels, and reserve depletion triggers anticipated devaluation. Delaying monetization while maintaining fiscal policy prolongs low inflation, but leads to higher inflation later. Introducing import restrictions alongside capital controls sustains the fixed exchange rate but misallocates resources, creating a wedge between domestic and international prices. This wedge, worsened by excessive money supply expansion, results in zero exports.