Capital Controls: Growth versus Stability∗

This paper provides a unified theoretical framework to analyze the macroeconomic consequences of capital account liberalizations and capital controls, like capital inflow taxes. It identifies two pecuniary externalities that lead to inefficient outcomes in terms of welfare and to financial instability. The first externality undermines the “terms of trade hedge” while the second leads to excessive liquidity mismatch and leverage. Short-term debt flows, i.e. “hot money”, stabilize the economy up to a certain level of global imbalance, but expose the system to sudden stops and financial instability. ∗We thank Mark Aguiar, Oleg Itskhoki and participants at the Princeton Macro faculty lunch. We also thank Zongbo Huang and Yu Zhang for excellent research assistance. †Brunnermeier: Department of Economics, Princeton University, [email protected], Sannikov: Department of Economics, Princeton University, [email protected]