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This paper investigates the role of exchange rate regime choices in the determination of capital controls in transition economies. We first use a simultaneous equations model to allow direct interactions between decisions on capital controls and on exchange rate regimes. We find that exchange rate regime choices strongly influence the imposition or removal of capital controls, but the feed-back effect is weak. We further estimate a single equation model for capital controls with exchange rate regime choices as independent variables, and we find that there is a hump-shaped relationship between exchange rate regime flexibility and capital control intensity.

A prominent feature of the Maastricht Treaty on European Union is the restrictions it places on fiscal policy. Under the provisions of the Excessive Deficit Procedure, or EDP, the success of member states in avoiding during the transition to economic and monetary union (EMU) is one of four criteria governing admission to the monetary union. Once monetary union has begun, member states are unconditionally required to avoid deficits. A state has an when it is so declared by the European Council upon a report by the European Commission and a judgment by the Monetary Committee. The EDP is set in motion if a country's deficit and general government debt respectively exceed 3 percent and 60 percent of GDP.' The justification for these procedures is that member states participating in the monetary union must be restrained from overborrowing to avoid destabilizing the common currency. If excessive deficits cause a debt crisis, the European Central Bank (ECB) will come under pressure to bail out the imperiled government. The bailout could be ex post (in which case the ECB would monetize the government's debt) or ex ante (in which case it would keep interest rates low to lighten the debt-service burden). Either way, unfettered fiscal policies could create inflationary pressures that the ECB will find difficult to resist.