Question

Let the home country be a large open economy. Assume that the home country wants to impose capital controls that prohibit foreign borrowing and lending by domestic residents. Analyze the effects of capital controls on country’s CA balance, national savings and investment, and on domestic and world real interest rates. Assume that before the capital controls were imposed, the home country had a large financial account surplus

Answer 1

In the diagram below, before the capital aacounts are imposed,the world interest rates is at .Left side is World/Foreign country and thr right side is Home country.

The Home country has a current account surplus measured as the positive difference between its national saving and desired investment at the world interest rate. It indicates that it is lending to foreign country whereas the foreign country has current account deficit and is borrowing from the Home country.

After the Home country imposes capital controls,each country will internally finance its desired investments and interest rates will move to the equilibrium saving and investment

As the Home country was lending to the world,domestic rates will fall to reduce savings and increase investmentss.When they are at equilibrium,the current account balance will be zero.

As the world was borrowing,domestic interest rates will increase to increase national saving and reduce investment.When they are at equilibrium,the current account balance will be zero.

For the Home country,domestic interest rates are lower after the control and the initial current account surplus has disappeared.