This paper shows that in a small open economy model with downward nominal wage rigidity pegging the nominal exchange rate creates a negative pecuniary externality.This peg-induced externality is shown to cause unemployment, overborrowing, and depressed levels of consumption.The paper characterizes the optimal capital control policy in this model and shows that it is prudential in nature.For it restricts capital inflows in good times and subsidizes external borrowing in bad times.Under plausible calibrations of the model, this type of macro prudential policy is shown to lower the average unemployment rate by 10 percentage points, reduce average external debt by more than 50 percent, and increase welfare by over 7 percent of consumption per period.
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