Capital controls and foreign currency denomination

This paper studies the effectiveness of capital controls with foreign currency denomination and its welfare implications. To do this, we develop a general equilibrium model with financial frictions and banking, in which assets and liabilities are denominated in both domestic and foreign currencies. We propose a non-pecuniary capital-control policy that limits the gap between foreign-currency denominated loans and deposits to the amount of foreign funds that bankers can borrow from the international credit market. We show that capital controls have a critical impact on the dynamics of assets and liabilities that are denominated in foreign currency. This critical impact works through the capital control constraint on quantitative financial variables directly, not through the spreads. The non-pecuniary capital controls help to stabilize the financial sector and, hence, reduces the negative spillovers to the real economy. A more restrictive capital-control policy significantly attenuates the welfare effect of the foreign monetary policy and exchange rate shocks.