Foreign Reserves and Capital Controls: Role of Financial Development

This paper develops a small-open-economy model to study optimal capital controls and foreign reserve policy. Private agents hold reserves to prepare for a liquidity shock that requires them to repay a part of outstanding foreign debt before new borrowing. A firesale externality associated with asset liquidation induces private agents to overborrow and accumulate too little reserves. The optimal policy calls for a tax on debt and either of a subsidy on private reserves or public foreign reserve accumulation. We show that the optimal debt tax rate becomes higher as the size of a potential liquidity shock becomes larger, but the optimal amount of foreign reserves is non-monotonic and maximized when the size of a potential liquidity shock is intermediate. This pattern is consistent with the observed cross-country relationships across financial development, capital controls, and foreign reserves.