CAPITAL CONTROLS AND THE GAINS FROM TRADE IN A BUSINESS-CYCLE MODEL OF A SMALL OPEN-ECONOMY

A dynamic stochastic model of a small open economy is used to quantify the macroeconomic effects of a policy that utilizes capital controls as an instrument to target the trade balance. The results show that, g iven the magnitude of actual business cycles, capital controls have ne gligible effects on agents' ability to smooth consumption and the leve l of welfare. These surprising results suggest that the benefits obtai ned from free trade as a mechanism that facilitates consumption smooth ing are of secondary importance. A fiscal strategy that enforces capit al controls by taxing foreign interest income is also studied.