## _wp04232

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---

### Introduction and context
- Until recently the National Bank of Romania (NBR) operated in a de facto exchange-rate-based framework using the exchange rate as an implicit nominal anchor to meet an annual disinflation target and moderate real effective appreciation.
- The NBR used its policy interest rate mainly to support exchange rate dynamics and reserve accumulation, aided by restrictions on nonresident purchases of treasury bills and bank deposits.
- Improved macroeconomic conditions, EU accession prospects, and a large yield differential led to sustained capital inflows and substantial reserve accumulation.
- The NBR intends to adopt inflation targeting (IT) in 2005, has stopped announcing real appreciation targets, and limited foreign-exchange interventions.
- Capital account liberalization is scheduled under EU accession: all restrictions on financial flows to be abolished by 2007 at the latest; some restrictions to be removed earlier. The NBR postponed lifting restrictions on nonresidents’ bank accounts originally scheduled for January 2004.

### Modeling approach and policy regimes analyzed
- Model:
  - Dynamic general-equilibrium model with sticky prices and monopolistic competition; main macro relations micro-founded.
  - Households, government, producers, and markets modeled with Calvo pricing (α), Dixit-Stiglitz aggregation (θ), money demand, and uncovered interest parity conditions (with/without capital controls).
- Policy regimes:
  - Old regime: partial capital mobility (Ζt) and an exchange-rate anchor (exchange-rate-based framework).
  - Emerging regime: free capital mobility (Ζt=1) plus inflation targeting (IT).
    - Flexible IT: policy responds to expected inflation, output, and the exchange rate.
    - Stricter IT: free-floating exchange rate (exchange rate floats freely; stricter CPI inflation targeting).

### Welfare criteria and parameterization (Section IV)
- Welfare measures:
  - Central bank loss function (equation (44)): weighted sum of variances of inflation (π_t), output gap (x_t), and real exchange rate (q_t).
    - Baseline weights: λ_π = 1.5; λ_x = 0.5; λ_q = 0.5.
  - Compensating variation (Lucas, 1987): fraction by which consumers’ original consumption basket must be increased to yield the same lifetime utility under the new regime.
- Caveats:
  - Second-order Taylor welfare difficult due to intermediate inputs and differing steady states; loss-function weights are ad-hoc and subjected to sensitivity analysis.
- Selected exact parameter values (Table 1):
  - β = 0.99
  - γ = 0.37
  - θ = 4.33 (sensitivity range: 4.33–20)
  - η = 0.60
  - α = 0.75
  - 1/υ = 0.50
  - σ = 1.10 (sensitivity range: 0.5–2)
- Derived coefficients:
  - IS: π_φ = 1.296; s_φ = 0.196; a_φ = 1.452
  - AS: x_κ = 0.0254; q_κ = 0.0175; y*_κ = 0.0039
  - Interest-rate rule (free capital mobility): (1−i_ρ)π_φ = 1.5; (1−i_ρ)x_φ = 0.1; (1−i_ρ)s_φ = 0.8; i_ρ = 0.8
  - Exchange-rate rule (capital controls): (1−s_ρ)x_χ = −0.1; (1−s_ρ)π_χ = −1.5; s_ρ = 0.8
- Shock persistence:
  - a_ρ = 0.9; y*_ρ = 0.9; i*_ρ = 0.9; ζ_ρ as in (43).

### Impulse-response experiments and key qualitative findings
- Shocks analyzed (capital-controls case):
  - (i) temporary halt in relaxing capital controls → 50-basis-point interest rate rise relative to baseline
  - (ii) 10 percent nominal exchange rate depreciation (one-off)
  - (iii) 25-basis-point foreign interest rate (i*) increase
  - (iv) 1 percent increase in foreign output (y*)
  - (v) 1 percent productivity (a) increase
- Key qualitative impulse-response summaries:
  - Capital-controls + exchange-rate rule:
    - Exchange-rate smoothing critical: higher smoothing → more stable CPI but higher real exchange-rate and output volatility.
    - Temporary intensification of controls: domestic interest rate rises; output and domestic inflation fall on impact; exchange rate depreciates; CPI impact negligible.
    - One-off depreciation: significant output increase via expenditure switching; CPI initial impact offset by subsequent appreciation.
  - Free capital mobility + flexible CPI IT:
    - Temporary domestic interest-rate rise → exchange rate appreciation and output fall on impact; policy subsequently reduces interest rate to promote convergence.
    - Exchange-rate shocks die out immediately via uncovered interest parity; managed float (interest-rate response) reduces output relative to free float.
    - CPI inflation more volatile vis-à-vis exchange-rate rule due to interest-rate smoothing.
  - Free capital mobility + free-floating exchange rate (stricter IT):
    - Exchange rate much more volatile and absorbs more shocks; output volatility significantly lower than in managed regimes.
    - Larger CPI jumps on impact for exchange rate, foreign interest rate, and technology shocks.
  - Flexible domestic inflation targeting vs CPI targeting: little difference except in responses to exchange-rate shocks when CPI is targeted.

### Unconditional variances (Table 2; numeric entries in percent by shock)
- Capital controls and exchange-rate rule (i* shock / Y* shock / Technology shock):
  - Domestic inflation: 0.00486 / 0.00001 / 0.00133
  - CPI: 0.00002 / 0.00002 / 0.00001
  - Output: 2.61790 / 0.06471 / 0.67441
  - Real exchange rate: 0.37222 / 0.00276 / 0.09938
- Free capital mobility and flexible CPI IT:
  - Domestic inflation: 0.00850 / 0.00004 / 0.00262
  - CPI: 0.00857 / 0.00003 / 0.00103
  - Output: 2.46656 / 0.06744 / 0.70708
  - Real exchange rate: 0.33689 / 0.00216 / 0.08253
- Free capital mobility and stricter CPI IT (free-floating ER):
  - Domestic inflation: 0.02549 / 0.00035 / 0.00242
  - CPI: 0.18036 / 0.00110 / 0.01833
  - Output: 0.17212 / 0.02648 / 0.14370
  - Real exchange rate: 1.35005 / 0.00844 / 0.23433
- Free capital mobility and flexible domestic IT:
  - Domestic inflation: 0.00891 / 0.00004 / 0.00266
  - CPI: 0.00826 / 0.00004 / 0.00122
  - Output: 2.50165 / 0.06750 / 0.69818
  - Real exchange rate: 0.33117 / 0.00215 / 0.08274

### Welfare analysis — central-bank loss function (Table 3)
- Losses by shock and regime (exact numeric entries)
  - Capital controls:
    - Interest rate shock: 0.01502
    - Exchange rate shock: 0.00034
    - Foreign interest rate: 0.00389
  - Free capital mobility (flexible CPI IT):
    - Interest rate shock: 0.00033
    - Exchange rate shock: 0.02364
    - Foreign interest rate: 0.01415
    - Foreign output: 0.00035
    - Technology: 0.00399
  - Free capital mobility (floating ER; stricter CPI IT):
    - Interest rate shock: 0.00281
    - Exchange rate shock: 1.06133
    - Foreign interest rate: 0.00799
    - Foreign output: 0.00018
    - Technology: 0.00193
  - Free capital mobility (flexible domestic IT):
    - Interest rate shock: 0.00026
    - Exchange rate shock: 0.03153
    - Foreign interest rate: 0.01423
    - Foreign output: 0.00035
    - Technology: 0.00395
- Interpretation:
  - Free-capital-mobility flexible IT performs about the same as capital-controls + exchange-rate rule under the loss function.
  - Free-floating exchange rate sharply reduces loss for the three common real/exogenous shocks but can raise loss for nominal shocks because of very large exchange-rate variance.
  - Sensitivity: results robust to variations in θ and σ for most ranges; free-floating IT superior for most θ and σ except at very low σ.

### Welfare analysis — compensating variation (Tables 5–7)
- Capital controls/exchange-rate rule versus Free capital mobility/flexible CPI IT (Table 5)
  - i* shock overall: 0.6582 (effect from different steady states: 0.6612; effect from different dynamics: −0.0030)
  - Y* shock overall: 0.6621 (steady state: 0.6612; dynamics: 0.0009)
  - Technology shock overall: 0.6575 (steady state: 0.6612; dynamics: −0.0037)
  - Interpretation: Free capital mobility/flexible IT yields welfare improvement ≈ 0.66 percentage points, driven largely by higher steady-state consumption after lower real interest rates.
- Capital controls/exchange-rate rule versus Free capital mobility/stricter CPI IT (free-floating ER) (Table 6)
  - i* shock overall: 0.8692 (steady-state 0.6612; dynamics 0.2080)
  - Y* shock overall: 0.6406 (steady-state 0.6612; dynamics −0.0205)
  - Technology shock overall: 0.7285 (steady-state 0.6612; dynamics 0.0673)
  - Interpretation: Free-floating IT adds welfare gains both from higher steady-state consumption and from dynamics (exchange rate absorbs foreign shocks), notably for i* and technology shocks.
- Flexible IT versus Stricter IT (Table 7: dynamics-only effects)
  - i* shock: 0.1970
  - Y* shock: −0.0214
  - Technology shock: 0.0707
  - Interpretation: Free-floating IT outperforms managed IT for i* and technology shocks; similar outcome for Y* shock.
- Robustness: Compensating-variation results robust to changes in θ and σ, though low σ reduces welfare gains from capital account liberalization because σ affects steady-state consumption.

### Key policy-relevant conclusions (Section VI)
- Regime trade-offs:
  - Capital-controls + exchange-rate rule stabilizes CPI inflation better than flexible IT with open capital markets but raises real exchange-rate volatility and sometimes output volatility.
  - Opening the capital account (free capital mobility) lowers real interest rates and raises steady-state output and consumption; compensating-variation welfare gain ≈ 0.66 percent for the baseline parameterization.
  - Flexible IT that includes the exchange rate in the reaction function has stabilizing properties similar to the exchange-rate-based regime.
  - Stricter IT with free-floating exchange rate better absorbs shocks (reduces output volatility) and yields higher welfare gains, at the cost of higher inflation volatility.
- Dependence on transmission and assumptions:
  - Results assume moderate shocks and rely on a reasonably strong transmission from policy interest rate to the real economy; strengthening transmission is necessary in the case studied (Romania).
  - Findings most applicable in the medium term after building experience with inflation targeting.
- Policy implications:
  - Financial opening is likely welfare-improving mainly via higher steady-state consumption (lower real interest rates).
  - Choice between managed and free-floating exchange-rate regimes under IT requires balancing CPI volatility against output and real exchange-rate stabilization: allowing the exchange rate to absorb shocks (free float) tends to reduce output volatility but raise CPI volatility.
  - Exchange-rate smoothing remains important when the exchange rate is the policy instrument under capital controls.

*Source: _wp04232 - Section IV defines the welfare criteria used for evaluating the models’ (extracted from the supplied PDF content).*

### References..............................................................................................................

### _wp04232 - References..............................................................................................................

### Introduction and context
- Until recently, the National Bank of Romania (NBR) operated in a de facto exchange-rate-based framework, relying on the exchange rate as an implicit nominal anchor to guide policy in line with the annual disinflation target and moderate real effective appreciation.
- The NBR used its policy interest rate mainly to support the targeted exchange rate dynamics and reserve accumulation, aided by existing restrictions on nonresident purchases of treasury bills and bank deposits.
- Improved macroeconomic conditions, the prospects for European Union accession, and a large yield differential between lei and foreign currency-denominated assets resulted in sustained capital inflows (bank borrowing and foreign direct investment) and substantial reserve accumulation.
- The NBR intends to adopt inflation targeting (IT) in 2005 and recently stopped announcing real appreciation targets and limited its interventions in the foreign currency market.
- Capital account liberalization is scheduled in the process of Romania’s EU accession: all restrictions on financial flows would be abolished by 2007 at the latest, and some of them would have to be dropped earlier. The NBR postponed lifting the restriction on nonresidents’ opening bank accounts originally scheduled for January 2004.

### Modeling approach and policy regimes analyzed
- The analysis employs a dynamic general-equilibrium model with sticky prices and monopolistic competition; main macroeconomic relations are explicitly derived from microeconomic foundations.
- The model combines these relations with monetary policy rules specific to:
  - the old regime: partial capital mobility and an exchange rate anchor (exchange-rate-based framework);
  - the emerging regime: free capital mobility plus inflation targeting (IT).
- Within the emerging regime, two variants of IT are distinguished:
  - flexible IT: monetary policy responds to deviations of expected inflation, output, and the exchange rate from their steady-state values;
  - stricter IT: the exchange rate is allowed to float freely (free-floating exchange rate).

### Evaluation criteria and metrics
- Performance is evaluated in terms of:
  - stabilization of inflation, output, and the real exchange rate;
  - two welfare criteria:
    - a standard central bank loss function containing deviations of inflation, output, and the real exchange rate from their equilibrium values;
    - the compensating variation measure of Lucas (1987): the fraction by which consumers’ original consumption basket must be increased for them to enjoy the same lifetime utility under each regime.

### Key findings and comparative results
- Both variations of the forthcoming monetary policy regime (flexible IT and stricter IT under free capital mobility) are superior in welfare terms to the exchange-rate-based framework used until recently.
  - Reason: capital account opening leads to lower interest rates and permanently higher output and consumption, yielding welfare gains despite increased inflation volatility under the IT regimes.
- Exchange-rate-based framework:
  - Best at stabilizing inflation.
  - Produces higher real exchange rate volatility because the nominal exchange rate—the policy instrument—directly influences CPI inflation and moves opposite to it in response to shocks.
- Flexible IT:
  - Best at stabilizing the real exchange rate, since inflation and the nominal exchange rate generally move together.
- Stricter IT (free-floating exchange rate):
  - By far superior in stabilizing output, as the free-floating exchange rate absorbs a larger part of shocks than the other two frameworks.
  - Minimizes the central bank loss for the three real and exogenous shocks experimented with.
  - Underperforms flexible IT on nominal shocks in terms of the central bank loss function because nominal shocks create excessive inflation and real exchange rate volatility under stricter IT.
  - Performs best according to the compensating variation (preferred welfare measure) owing to both a permanent increase in steady-state consumption and superior stabilizing properties.

### Model implementation notes and supporting materials (as presented)
- Figures referenced:
  - Figure 1. Exchange Rate Path of the Leu versus a EUR-US$ Basket (monthly series shown for Jan-03 to Oct-04; chart notes: EUR-US$ weights are 60-40 for 2003 and 75-25 for 2004; notional target based on announced annual targets for inflation and real exchange rate appreciation).
  - Figure 2. Capital Controls and an Exchange Rate Rule
  - Figure 3. Free Capital Mobility and Flexible CPI Inflation Targeting
  - Figure 4. Free Capital Mobility and Stricter Inflation Targeting (Free-Floating Exchange Rate)
  - Figure 5. Free Capital Mobility and Flexible Domestic Inflation Targeting
  - Figure 6. Sensitivity of Welfare Loss (Central Bank Loss Function) to Changes in Price Elasticity of Demand (Theta) and Intertemporal Elasticity of Substitution (Sigma)
  - Figure 7. Sensitivity of Welfare Gains (Compensating Variation) to Changes in Price Elasticity of Demand (Theta) and Intertemporal Elasticity of Substitution (Sigma)
- Tables referenced:
  - Table 1. List of Parameter Values
  - Table 2. Unconditional Variances of the Main Variables
  - Table 3. Welfare Results According to a Central Bank Loss Function
  - Table 4. Sensitivity of Welfare Result to Loss-Function Weights
  - Table 5. Welfare Comparison According to Compensating Variation: Capital Controls/Exchange Rate Rule Versus Free Capital Mobility/Flexible CPI Inflation Targeting
  - Table 6. Welfare Comparison According to Compensating Variation: Capital Controls/Exchange Rate Rule Versus Free Capital Mobility/Stricter CPI Inflation Targeting (Free-Floating Exchange Rate)
  - Table 7. Welfare Comparison According to Compensating Variation: Flexible Versus Stricter CPI Inflation Targeting

*Source: _wp04232 - References..............................................................................................................*

### Section IV defines the welfare criteria used for evaluating the models’

### _wp04232 - Section IV defines the welfare criteria used for evaluating the models’

### Model structure: households, government, producers, and markets
- Households
  - Continuum of identical infinitely lived households indexed by j∈[0,1] specializing in production of a single differentiated good.
  - Lifetime utility (equation (1)) with discount factor β between 0 and 1; disutility of labor represented by υ; consumption and real money balances enter additively separable.
  - Composite consumption (equation (2)) with share of foreign goods γ and unitary elasticity of substitution between domestic and foreign goods.
  - Dixit-Stiglitz aggregation for consumption indices with price elasticity θ>1 (equation (3)).
  - Flow and intertemporal budget constraints summarized in (4), (5), and (7); first-order conditions (8) and (9) and money demand (11). Central bank controls the one-period nominal interest rate; money supply follows money demand.
  - Labor supply optimality condition (12).
  - Rest of world (ROW) treated as exogenous; when financial markets are complete, home consumption linked to world consumption via (15) with real exchange rate Qt = S_t P*_t / P_t.
  - Capital controls represented by Ζt with Ζt>0; Ζt=1 returns to free capital mobility. Log of Ζt follows autoregressive process with drift (17).

- Government
  - Period budget constraint (18) with proportional sales tax τ; assumption (1−τ)=μ to offset monopolistic competition markup μ so price rigidity is sole distortion.

- Producers
  - Production function (19): Y_t(j)=A_t h_t(j)^{η} I_t(j)^{1−η} where A_t is exogenous technology and I_t imported inputs.
  - Nominal marginal cost given in (21) with elasticity ω of marginal cost w.r.t. firm’s own output.
  - Calvo pricing with fraction α of prices unchanged each period (22). Profit maximization and first-order condition for new optimal price given in (25)–(27). Real marginal cost mc_t ≡ MC_t / P_{h,t}.

- Equilibrium and log-linearization
  - All terms in Section III are percentage deviations from steady states (lower-case).
  - Open economy IS curve (28) and money demand (29).
  - Aggregate supply (32); CPI inflation expressed in (33).
  - With capital controls, interest rate wedge ζ_t enters uncovered interest parity (34). With free mobility, uncovered interest parity holds (35).
  - Market-clearing consumption-output relation given in (36) and (37).
  - Monetary policy:
    - With partial capital controls central bank instrument is the exchange rate; exchange-rate rule given in (38) with smoothing s_ρ and coefficients χπ, χx and shock s_ε.
    - With free capital mobility central bank sets interest rate per rule (39) with smoothing i_ρ and coefficients φπ, φx, φs and shock i_ε.
  - Four exogenous AR processes (40)–(43) with i.i.d. zero-mean errors.

### Welfare criteria (Section IV)
- Two welfare measures used:
  - Central bank loss function (for comparability with literature), equation (44):
    - L = E[Var(π_t) λ_π + Var(x_t) λ_x + Var(q_t) λ_q]  (written in the source as a weighted sum of variances)
    - Weights used in baseline: λ_π = 1.5, λ_x = 0.5, λ_q = 0.5 (Table 1).
  - Compensating variation (preferred): Lucas (1987) measure — fraction by which consumers’ original steady state consumption basket must be increased to yield the same lifetime utility under the new regime as under the old.
- Caveats:
  - Second-order Taylor welfare is ideal but difficult due to intermediate inputs, labor disutility approximation, and differing steady states between models.
  - Ad-hoc weights in loss function are subject to sensitivity analysis; compensating variation explicitly calculates steady state consumption shifts and consumption paths in response to shocks.

### Parameterization (selected exact values from Table 1)
- Core parameters:
  - β = 0.99
  - γ = 0.37
  - θ = 4.33 (sensitivity range analyzed: 4.33–20)
  - η = 0.60
  - α = 0.75 (price adjustment frequency once in four quarters)
  - 1/υ = 0.50
  - σ = 1.10 (intertemporal elasticity of substitution; sensitivity range analyzed: 0.5–2)
- Derived coefficients (IS / AS / policy)
  - IS: π_φ = 1.296; s_φ = 0.196; a_φ = 1.452
  - AS: x_κ = 0.0254; q_κ = 0.0175; y*_κ = 0.0039
  - Interest-rate rule (free capital mobility): (1−i_ρ)π_φ = 1.5; (1−i_ρ)x_φ = 0.1; (1−i_ρ)s_φ = 0.8; i_ρ = 0.8
  - Exchange-rate rule (capital controls): (1−s_ρ)x_χ = −0.1; (1−s_ρ)π_χ = −1.5; s_ρ = 0.8
- Shock persistence
  - a_ρ = 0.9; y*_ρ = 0.9; i*_ρ = 0.9; ζ_ρ as in (43).
- Central bank loss-function weights (baseline)
  - λ_π = 1.5; λ_x = 0.5; λ_q = 0.5

### Impulse response experiments (regimes and shocks)
- Shocks analyzed (capital controls case): 
  - (i) temporary halt in relaxing capital controls → 50-basis-point interest rate rise relative to baseline,
  - (ii) 10 percent nominal exchange rate depreciation (one-off),
  - (iii) 25-basis-point foreign interest rate (i*) increase,
  - (iv) 1 percent increase in foreign output (y*),
  - (v) 1 percent productivity (a) increase.
- Key qualitative impulse-response findings (summarized):
  - Capital-controls + exchange-rate rule:
    - Temporary intensification of controls: domestic interest rate rises, output and domestic inflation fall on impact; exchange rate depreciates; CPI impact negligible.
    - One-off depreciation: significant output increase via expenditure switching; CPI initial impact offset by subsequent appreciation.
    - Foreign interest rate increase: domestic interest rate rises, lowering output and domestic inflation; exchange rate depreciates with expectations amplifying interest rate via parity.
    - Foreign output increase: domestic output and inflation rise; exchange rate appreciates; CPI inflation falls overall.
    - Productivity shock: output up, domestic inflation down; exchange rate depreciates (policy reaction), interest rate rises; CPI impact negligible.
    - Exchange rate smoothing critical to stabilize CPI; higher smoothing → more stable CPI but higher volatility of real exchange rate and output.
  - Free capital mobility with flexible CPI IT:
    - Temporary interest-rate increase → exchange rate appreciation and output fall on impact; subsequent policy reduces interest rate, promoting convergence.
    - Exchange-rate shocks die out immediately via uncovered interest parity; managed float implies interest-rate response that reduces output compared to free float.
    - Foreign interest rate shock: domestic interest rate rises less than proportionately; exchange rate adjusts; CPI shows jump then reversal.
    - Productivity shock: output up, domestic inflation down; policy cuts interest rates, amplifying output gains; CPI falls below steady state after initial dynamics.
    - CPI inflation more volatile under flexible IT vis-à-vis exchange-rate rule due to interest-rate smoothing vs exchange-rate smoothing.
  - Free capital mobility with free-floating exchange rate (stricter IT):
    - Exchange rate much more volatile; larger CPI jump on impact for exchange rate, foreign interest rate, and technology shocks.
    - Exchange-rate volatility absorbs more shocks → output volatility significantly lower than in managed regimes.
  - Flexible domestic inflation targeting vs CPI targeting: little difference in responses except for exchange-rate shock when CPI is targeted.

### Unconditional variances (Table 2, exact numeric entries in percent)
- Capital controls and exchange-rate rule (i* shock / Y* shock / Technology shock):
  - Domestic inflation: 0.00486 / 0.00001 / 0.00133
  - CPI: 0.00002 / 0.00002 / 0.00001
  - Output: 2.61790 / 0.06471 / 0.67441
  - Real exchange rate: 0.37222 / 0.00276 / 0.09938
- Free capital mobility and flexible CPI IT:
  - Domestic inflation: 0.00850 / 0.00004 / 0.00262
  - CPI: 0.00857 / 0.00003 / 0.00103
  - Output: 2.46656 / 0.06744 / 0.70708
  - Real exchange rate: 0.33689 / 0.00216 / 0.08253
- Free capital mobility and stricter CPI IT (free-floating ER):
  - Domestic inflation: 0.02549 / 0.00035 / 0.00242
  - CPI: 0.18036 / 0.00110 / 0.01833
  - Output: 0.17212 / 0.02648 / 0.14370
  - Real exchange rate: 1.35005 / 0.00844 / 0.23433
- Free capital mobility and flexible domestic IT:
  - Domestic inflation: 0.00891 / 0.00004 / 0.00266
  - CPI: 0.00826 / 0.00004 / 0.00122
  - Output: 2.50165 / 0.06750 / 0.69818
  - Real exchange rate: 0.33117 / 0.00215 / 0.08274

### Welfare analysis: central-bank loss function (Table 3) — losses by shock and regime
- Capital controls:
  - Interest rate shock: 0.01502
  - Exchange rate shock: 0.00034
  - Foreign interest rate: 0.00389
- Free capital mobility (flexible CPI IT):
  - Interest rate shock: 0.00033
  - Exchange rate shock: 0.02364
  - Foreign interest rate: 0.01415
  - Foreign output: 0.00035
  - Technology: 0.00399
- Free capital mobility (floating ER; stricter CPI IT):
  - Interest rate shock: 0.00281
  - Exchange rate shock: 1.06133
  - Foreign interest rate: 0.00799
  - Foreign output: 0.00018
  - Technology: 0.00193
- Free capital mobility (flexible domestic IT):
  - Interest rate shock: 0.00026
  - Exchange rate shock: 0.03153
  - Foreign interest rate: 0.01423
  - Foreign output: 0.00035
  - Technology: 0.00395
- Interpretation:
  - Baseline free-capital-mobility flexible IT performs about the same as capital-controls + exchange-rate rule under the central-bank loss.
  - Free-floating exchange rate sharply reduces loss for the three common (real/exogenous) shocks but can raise loss for nominal shocks due to large exchange-rate variance.
- Sensitivity of loss-function results:
  - Robust to variation in θ and σ for most parameter ranges; free-floating IT superior for most θ and σ except at very low σ where real exchange-rate volatility raises losses.
  - Table 4 sensitivity cases (two alternative weight sets) show free-floating IT remains superior for the three real shocks.

### Welfare analysis: compensating variation (Tables 5–7)
- Comparison: Capital controls/exchange-rate rule vs Free capital mobility/flexible CPI IT (Table 5)
  - Overall effect (i* shock): 0.6582
  - Effect from different steady states: 0.6612
  - Effect from different dynamics: −0.0030
  - For Y* shock overall: 0.6621 (0.6612 steady state; 0.0009 dynamics)
  - For Technology shock overall: 0.6575 (0.6612 steady state; −0.0037 dynamics)
  - Interpretation: Free capital mobility/flexible IT yields welfare improvement ≈ 0.66 percentage points, driven largely by higher steady-state consumption after lower real interest rates; stabilization properties differ little.
- Comparison: Capital controls/exchange-rate rule vs Free capital mobility/stricter CPI IT (free-floating ER) (Table 6)
  - i* shock overall: 0.8692 (steady-state 0.6612; dynamics 0.2080)
  - Y* shock overall: 0.6406 (steady-state 0.6612; dynamics −0.0205)
  - Technology shock overall: 0.7285 (steady-state 0.6612; dynamics 0.0673)
  - Interpretation: Free-floating IT adds welfare gains both from higher steady-state consumption and from dynamics (exchange rate absorbs foreign shocks), especially for i* and technology shocks.
- Comparison: Flexible IT (managed ER) vs Stricter IT (free-floating ER) (Table 7)
  - Dynamics-only effects:
    - i* shock: 0.1970
    - Y* shock: −0.0214
    - Technology shock: 0.0707
  - Interpretation: Free-floating IT outperforms managed IT for i* and technology shocks; similar for Y* shock.
- Robustness: Compensating-variation results robust to parameter changes (θ and σ), though low σ reduces welfare gains from capital account liberalization because σ affects steady-state consumption.

### Key policy-relevant conclusions (Section VI)
- Regime trade-offs
  - Capital-controls + exchange-rate rule stabilizes CPI inflation better than flexible IT with open capital markets but at the cost of higher real exchange-rate volatility and sometimes higher output volatility.
  - Opening the capital account (free capital mobility) lowers real interest rates and raises steady-state output and consumption; compensating-variation welfare gain ≈ 0.66 percent for the baseline parameterization.
  - Flexible IT that includes the exchange rate in the reaction function has stabilizing properties similar to the exchange-rate-based regime.
  - Stricter IT with free-floating exchange rate is superior for absorbing shocks (reducing output volatility) and producing higher welfare gains, but implies higher inflation volatility.
- Dependence on transmission and assumptions
  - Results depend on moderate shocks that do not alter the steady-state or transmission mechanisms.
  - Gains from financial integration and IT + free float rely on a reasonably strong transmission from policy interest rate to real economy — a transmission that needs strengthening in the case studied (Romania).
  - Thus results are most applicable in the medium term after experience with inflation targeting is built.
- Policy implications
  - Financial opening is likely welfare-improving primarily via higher steady-state consumption (lower real interest rates).
  - Choice between managed and free-floating exchange-rate regimes under IT involves balancing CPI volatility against output and real exchange-rate stabilization; allowing the exchange rate to absorb shocks (free float) tends to reduce output volatility but raise CPI volatility.
  - Exchange-rate smoothing remains an important tool when the exchange rate is the policy instrument under capital controls.

*Source: _wp04232 - Section IV defines the welfare criteria used for evaluating the models’ (extracted from the supplied PDF content).*

### REFERENCES

### REFERENCES

### References list
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*Source: _wp04232 - REFERENCES*

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