Using monetary policy to regulate foreign capital flows

The objective of this study is to deepen our understanding of specific capital controls that are appropriate for managing capital inflows and the circumstances under which these controls apply. We use market-based restrictions on capital inflows. Specifically, we choose a Tobin tax on foreign investment funds to induce investors to increase their asset holding periods before making further transactions. The tax depends on economic conditions, market-oriented regulatory reforms, and the political process in the developing country. The influence of each factor on the tax is difficult to disentangle, so the developing country’s government uses discretion in the application of the tax.

We conduct a game theoretical analysis in a multi-period open market economy to highlight dynamic strategic interaction between a developing country’s government and foreign investors. We assume risk-neutral foreign investors who face a Tobin tax on foreign funds invested in the developing country. There are no taxes in the home country to enable us to analyse the efficacy of the developing country’s monetary policy to regulate foreign capital flows into the country. The residents of the developing country are passive. Foreign investors invest their funds in their home country and the developing country to maximise their expected returns. The developing country’s government applies the tax on foreign investment funds to influence the composition of capital inflows. We use the sub-game perfect Nash equilibrium concept in the analysis. We solve the multi-period game by solving the associated sub-games in a backward process. The Nash equilibrium for the overall game consists of the Nash equilibria obtained for the associated subgames.

The insights derived in this analysis are as follows. The government will impose a positive amount of tax if returns on foreign investments in the developing country exceed a threshold chosen by the government. In setting this threshold, the government takes into account the economic conditions, regulatory supervision, and the political process in the country.