CAPITAL CONTROL AND DOMESTIC INTEREST RATES: A GENERALIZED MODEL

This article addresses the question of capital control (inflow) and its varied effect on interest rates and real-side economy. The moral hazard problem causes interest rates to increase as a function of external debt. Decreased capital inflow (external debt) can reduce moral hazard and outweigh the effect of costly capital transactions, with capital control decreasing interest rates and increasing output. This result runs counter to other theoretical works on capital control. The policy implication is that a government can generate national gains from capital inflow control by prohibiting new external debt (borrowing from abroad). With old debt retired and no new borrowing from abroad, external debt is reduced. This will reduce the moral hazard problem and lead to a drop in interest rates and an increase in output. (JEL "F32", "F41", "E43") Copyright 2005 Western Economic Association International.