Do Capital Controls Enhance Monetary Independence?

• Author: Yu You,Yoonbai Kim,Xiaomei Ren
• Published date: 01 August 2014
• DOI: http://doi.org/10.1111/rode.12097
• Date: 01 August 2014

Do Capital Controls Enhance Monetary

Independence?

Yu You, Yoonbai Kim, and Xiaomei Ren*

Abstract

International monetary policy trilemma—the tradeoff among exchange rate stability, monetary independ-

ence, and unrestricted capital mobility—is an important constraint for policy makers in an open economy.

This paper investigates an aspect of the hypothesis that has received relatively less attention: whether a

decrease in capital mobility through imposition of capital controls, while holding the degree of exchange

rate stability constant, will enhance monetary independence. Using a panel dataset covering 88 countries

for the 1995–2010 period and the generalized method of moments (GMM) estimation, we find that: (1)

capital controls help improve a country’s monetary independence; (2) the effectiveness of capital controls

depends on the types of assets and the direction of flows that are imposed; and (3) the choice of exchange

rate regime has an important impact on the effectiveness of capital controls on monetary independence.

1. Introduction

According to the international monetary policy trilemma, policymakers simulta-

neously may achieve any two, but not all, of the following three goals: (1) exchange

rate stability; (2) unrestricted movement in international capital; and (3) monetary

policy autonomy. The first goal, exchange rate stability, requires a fixed or heavily

managed exchange rate regime. The second goal, free capital mobility, is usually asso-

ciated with elimination of exchange controls on cross-border movement of interna-

tional capital. The third goal, monetary policy autonomy is conceptual and thus

difficult to define. Usually if a country can easily implement its own monetary policy

without being forced to follow another country’s monetary policy, it is considered to

have a high level of monetary independence. One of most popular measures of mon-

etary independence is deviation of the domestic interest rate from the foreign or base

rate. Aizenman et al. (2010), Frankel et al. (2004) and Shambaugh (2004) examine

monetary independence using this metric.

Previous studies in the trilemma mostly focus on the relationship between the

exchange rate regime and monetary policy independence. See, inter alia, Di Giovanni

and Shambaugh (2008), Bluedorn and Bowdler (2010), Frankel et al. (2004) and

Shambaugh (2004). Most studies assume high capital mobility especially when indus-

trialized economies are under consideration. In this case, the trilemma is reduced to a

simpler dilemma between exchange rate stability and monetary independence. For

various reasons, however, the tradeoff between capital mobility and monetary

independence—for instance, whether introducing more stringent capital controls will

enhance monetary independence—has been limited to case studies. An important

* Kim: Department of Economics, American University of Sharjah, PO Box 26666, Sharjah, UAE; Tel:

+971-6-515-4624; Fax: +971-6-515-2550; E-mail: ykim@aus.edu. Yu: Capital University of Economics and

Business, Beijing, China. Ren: Southern Methodist University, Dallas, TX 75275-0100, USA. The authors

wish to thank two anonymous referees and the editor for their helpful comments. Any remaining errors are

their own.

Review of Development Economics, 18(3), 475–489, 2014

DOI:10.1111/rode.12097

© 2014 John Wiley & Sons Ltd