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Excessive Volatility in Capital Flows: A Pigouvian Taxation Approach
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Excessive Volatility in Capital Flows: A Pigouvian Taxation Approach
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Journal Article
Excessive Volatility in Capital Flows: A Pigouvian Taxation Approach
2010
Overview
This paper presents a welfare case for prudential controls on capital flows to emerging markets as a form of Pigouvian taxation that aims to reduce the externalities associated with the deleveraging cycle. We argue that restricting capital inflows during boom times reduces the potential outflows during busts. This mitigates the feedback cycle during such deleveraging episodes, when tightening financial constraints on borrowers and collapsing prices of collateral assets mutually reinforce each other. As a result, macroeconomic volatility is smoothed and welfare is unambiguously increased. This paper presents a simple model of collateralized international borrowing, in which the value of collateral assets endogenously depends on the state of the economy. When financial constraints are binding in such a setup, financial amplification effects (sudden stops) arise as declining collateral values, tightening financial constraints and falling consumption mutually reinforce each other. Such amplification effects are not internalized by individual borrowers and constitute a negative externality that provides a natural rational for the Pigouvian taxation of international borrowing.
Publisher
American Economic Association,American Economic Assoc
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