Capital Control, Speculation and Exchange Rate Volatility

This paper studies a plausible connection among rational speculators, exchange rate volatility and capital controls. When Krugman (1999) asserted that there should be appropriate controls on international capital movements to avoid currency volatilities from speculative activities, this paper shows whether to take capital controls depends on types of shocks and the risk preference of rational speculators. (1)If only current account shocks occur, the increase in the risk preference of rational speculators will decrease the conditional variance of exchange rates. In this case, the best policy is to let capitals freely move in the world. (2)If only interest rate shocks occur, the conditional variance of the exchange rate is monotonically increasing in the risk preference of rational speculators. Under such circumstance, the controls over international capital movements indeed decrease the exchange rate volatility. (3)When both current account and capital account shocks occur, then, if speculators are more risky, capital controls decrease exchange-rate volatility; however, if speculators are less risky, free capital movements can temper the exchange rates response to transitory shocks