Rules versus discretion: A case for capital controls

This dissertation focuses on the credibility of a monetary authority that seeks to peg its nation's exchange rate. If the monetary authority's commitment to a policy rule is credible, then it maintains a fixed exchange rate. This dissertation attempts to study the effects of a target rate of currency depreciation, capital controls, and the timing of monetary policy actions on the credibility of the monetary authority.; A standard small open economy rational expectations model is used to study the credibility of the monetary authority's commitment. The monetary authority's credibility is evaluated in a framework similar to the one developed by Barro-Gordon (1983).; The absence of a target depreciation rate reduces the monetary authority's credibility. In the presence of capital controls, the target depreciation rate does not impact on the credibility of the monetary authority. The use of capital controls can be justified if the monetary authority is concerned about stabilizing the economy and imported inflation. The capital controls insulate the economy from the effects of demand shock and imported inflation. The erosion of capital controls with time induces variability in output growth and inflation rate.; If the monetary authority does not stabilize the economy and there is no imported inflation, then the monetary authority's commitment is credible. The presence of a target depreciation rate further improves the monetary authority's credibility.; In the special case where the monetary authority does not stabilize the economy and capital controls are present, the absence of imported inflation makes the monetary authority's commitment credible.; Overall, the monetary authority's credibility improves when the economy is stable and distortions in the economy are high. The presence of a target rate of depreciation enhances the credibility of the monetary authority's commitment. Capital controls do not have any effect on the monetary authority's credibility. Capital controls are able to protect the output growth from demand shocks. Hence, demand shocks may be one of the reasons to use capital controls. The use of capital controls should be restricted to short periods of time because with time the controls tend to become ineffective and increase the variability of output growth.