The effect of capital controls on interest rate differentials

In this paper we present a model of international interest rate arbitrage u nder conditions of entry and exit costs to and from the domestic capital ma rket. We seek to measure the maximum potential effect of capital controls, such as non-interest paying reserve requirements, on interest rate differen tials. We quantify the effect of such taxes using a dynamic optimization mo del with uncertainty and transaction costs. An optimal (S,s) rule gives the limits for interest rate differentials that trigger capital inflows and ou tflows. We also calculate maximum interest rate differentials for various m aturities and study the effect of parameter changes. Using parameters estim ated for the Chilean economy, the model shows that the effect of capital co ntrols on interest rate differentials is considerably smaller than what sta tic calculations suggest. (C) 2001 Elsevier Science B.V. All rights reserve d.