Capital Controls and Misallocation

We study the effects of international flow volatility on the productivity of an economy and the desirability of a capital control. Productivity is endogenous, and depends on the allocations of resources. Entrepreneurs can decide either to do a small project (akin to services) or a big project (akin to manufacturing). Due to financial frictions they require some funding that they obtain via the international investors. International investors are of two types: short-term and long-term. Long-term investors are subject to a shock to its opportunity cost — a sudden stop. Thus, there is expected volatility in the interest rate. This makes entrepreneurs decide on smaller or less productive projects, as to avoid the risk. Thus, an aggregate shock to the interest rate interacts with the financial friction to generate misallocation. A capital control has two effects. On the one one hand, it decreases the amount of liquidity of the economy. On the other hand, reduces the volatility of the interest rate. This increases productivity and thus increases the supply of funds from long term investors, thus partially offsetting the liquidity effect. The model is consistent with several facts regarding sudden stops. We explore the quantitative effects in a model of occupational choice with two sectors, and financial frictions as in Buera, Kaboski and Shin (2011), where we include international investors and aggregate uncertainty.