By Fabrizio Perri and Jonathan Heathcote
In a standard two country international macro model we ask whether shutting down the market for international non-contingent borrowing and lending is ever desirable. The answer is yes. Imposing capital controls is unilaterally desirable when initial conditions are such that ruling out bond trade generates a sufficiently favorable change in the expected path for the terms of trade. Imposing capital controls can be welfare improving for both countries for calibrations in which changes in equilibrium terms of trade movements induced by the controls improve insurance against country specific shocks.
Nice paper that goes against general intuition that capital controls are always bad. It is remarkable that the model can show that they can be beneficial to both countries under some conditions. And those conditions are likely broader than what the authors indicate, as this type of model typically understates the volatility of the terms of trade.