Capital controls, exchange rate volatility and risk premium

Capital controls lower the variability of the exchange rate and reduce the risk premium as well as the domestic interest rate. On the other hand, capital controls reduce the number of noise traders and, therefore, the risk-bearing capacity of the market, leading to higher interest rates and a lower growth potential of the economy. The identification of these two effects which work in opposite directions are the result of a study on the effect of capital controls on the exchange rate, the domestic interest rate, and the microstructure of the foreign exchange market in a small open economy.