Capital Controls and Price Stability in a Small Open Economy with Habit Persistence

This paper introduces habit persistence in consumption into otherwise a canonical new Keynesian small open economy. Households’ decision to suboptimally adjust their consumption and labor hours entails a prolonged undesirable terms of trade externality, leaving room for government to improve welfare by controlling international capital movement even in the economy with flexible prices and the Cole-Obstfeld preference, irrespective of nominal price rigidities. It shows that government can improve welfare by intervening capital movement across border in a small open economy with flexible prices, even if there are only permanent productivity shocks, contrasting with Farhi and Werning (2014). The paper also finds that higher the degree of habit persistence, more aggressive capital control to international capital movement required to stabilize the economy and to improve upon the welfare of either the flexible or sticky price economy. The nominal interest rate should countercyclically move to complement the procyclical capital control tax in stabilizing the capital movement across border. Moreover, the resource allocations associated with both optimal time-varying capital control show less volatile movements than the ones without any intervention.