Capital controls and international trade finance

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Abstract

This paper studies the effects of prohibiting individuals from holding foreign assets, but of allowing firms to trade in foreign assets only up to what is needed to finance export and import activities. Although firms can perform arbitrage between domestic and foreign financial markets, the distortions in asset markets are not fully arbitraged away but instead are transmitted to domestic goods markets. The dynamics and steady-state responses to a variety of shocks are crucially affected by capital controls. Even in the presence of capital controls, the volatility of domestic interest rates can be substantial.

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We are grateful to Reena Mithal for research assistance and to Ingrid Werner, Michael Burda and seminar participants at Harvard University and the University of Rochester for comments. Robert Hodrick's numerous suggestions on all revisions of the paper have been extremely valuable, and are gratefully acknowledged. Of course, we retain all responsibility for any remaining errors. This paper is part of a CEPR research program on ‘Financial and Monetary Integration in Europe’ supported by a grant from the Commission of the European Communities under its SPES Programme (no. E89300105/RES).