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Effects of capital controls on foreign exchange liquidity

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Abstract

This paper investigates from a theoretical and empirical perspective the effects of capital controls on cost-based measures of foreign exchange (FX) market liquidity. First, we propose a market microstructure model of the exchange rate where capital controls reduce the trades of constrained dealers. The effect is a tightening of the effective spread, which increases market liquidity. Then, we propose a new measure of capital account restrictiveness that, in contrast to other traditional measures, can account for intensive changes in capital controls policies. Using this measure in a panel of emerging market economies, we provide empirical evidence showing that capital controls can reduce the implicit cost component of FX market liquidity.

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  • Cantú, Carlos, 2019. "Effects of capital controls on foreign exchange liquidity," Journal of International Money and Finance, Elsevier, vol. 93(C), pages 201-222.
    • Handle: RePEc:eee:jimfin:v:93:y:2019:i:c:p:201-222
    DOI: 10.1016/j.jimonfin.2019.01.006
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    More about this item

    Keywords

    Capital flow management policies; Foreign exchange market; Market liquidity; Effective spread; FX liquidity measures;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F38 - International Economics - - International Finance - - - International Financial Policy: Financial Transactions Tax; Capital Controls
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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