A Welfare Analysis of Capital Account Liberalization


  • We thank Helge Berger, James Bullard, Menzie Chinn, Robert Kollmann, Ludger Linnemann, Harald Uhlig, and seminar participants at the University of Bonn, the CESifo–Delphi Conference, St. Louis Fed, EEA 2006 in Vienna, SAE 2006 in Oviedo, and ASSA 2007 in Chicago.

von Hagen: Institute for International Economics, University of Bonn, Indiana University, and CEPR. Lennestrasse 37, 53113 Bonn, Germany. Tel: +49-228-739199; Fax: +49-228-737953; E-mail: vonhagen@uni-bonn.de. Zhang: School of Economics, Singapore Management University, 90 Stamford Road, Singapore 178903. Tel: +65-68280665; Fax: +65-68280833; E-mail: hpzhang@smu.edu.sg.


We develop a model of a small open economy with credit market frictions to analyze the consequences of capital account liberalization. We show that financial opening facilitates the inflows of cheap foreign funds and improves production efficiency. However, capital account liberalization has important distributional consequences. Specifically, it may be impossible to use public transfers to fully compensate the loss of those who are negatively affected by capital account liberalization. This explains why financial opening often meets fierce opposition even though it leads to efficiency gains for the economy as a whole. From a practical perspective, capital controls should be lifted gradually for a smooth transition.