A Welfare Analysis of Capital Account Liberalization ∗

We develop a model of a small open economy with credit market frictions to analyze the consequences of capital account liberalization. We show that finan-cial opening facilitates the inflows of cheap foreign funds and improves production efficiency. Reforms increasing labor market flexibility can further improve such efficiency gains. However, capital account liberalization also has important distri-butional consequences. Specifically, it may be impossible to use public transfers to fully compensate the loss of those negatively affected by capital account liberaliza-tion. This explains why financial opening often meets fierce opposition even though it leads to efficiency gains for the economy as a whole. From a practical perspective, capital controls should be lifted gradually for a smooth transition. JEL Classification: E32, E44, F4