A Managed Policy on Capital Inflows

Abstract

Cross-border capital flows create dilemmas and trade-offs for monetary policy due to their many benefits, like financing economic growth and consumption of households, and their potential adverse macroeconomic effects, which can be caused by real appreciation of a recipient country’s currency and a large stock of debt that can cause difficulty in servicing. We examine conditions under which a country will restrict capital inflows to mitigate their adverse macroeconomic effects. Our game-theoretic modelling captures a dynamic interaction between policy and investment. Using the subgame perfect Nash equilibrium concept, we show that the government restricts capital inflows if the local economic conditions are strong enough to discourage a surge in capital inflows but relaxes the restriction if the economic conditions in the investors’ home are strong enough to attract capital inflows. The restriction has large impact on short-term capital inflows and is effective in channelling capital inflows into long-term investments.