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Exchange Rate, Capital Flow and Output: Developed versus Developing Economies

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Abstract

This paper aims to study the impact of exchange rate and capital flows on output in one unifying model. To explore this issue, we apply a vector auto-regression (VAR) model with Cholesky decomposition to a group of developed economies (Canada, Switzerland, Australia, Italy, the Netherlands, and Spain) and developing economies (Mexico, Indonesia, Korea, Malaysia, Philippines, Brazil, and Chile). The sample period varies for each country with the longest for Switzerland (1970:1–2010:3) and the shortest for Chile (1996:1–2010:3). The findings suggest first that contractionary devaluation is more likely to happen in developing countries while expansionary devaluation is more prevalent in developed countries. Second, the current account tends to improve in some of the countries facing currency depreciation. However, whether output increases after a real devaluation or not has little to do with whether the current account improves or not. Third, in response to capital inflows, output in developed countries are largely unaffected, while output in developing countries generally increases.

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Notes

  1. In a textbook model, adverse external shocks lead to a depreciation of the real exchange rate that by stimulating net exports, boosts aggregate demand and offsets the effects of the initial shock. Therefore, flexible exchange rates can absorb adverse external shocks.

  2. See Edwards (1986) for the summary of the theoretical background of contractionary devaluation effect on output.

  3. The summary of the table for exchange rate regime classification from 1997 to 2007 is available upon request.

  4. Nominal effective exchange rate is the trade-weighted average of bilateral exchange rates against the US dollar. The weighting schemes are as follows: for Australia, (US, Japan, UK) = (0.33, 0.33, 0.33), for Spain, (Germany, France, Italy) = (0.4, 0.4, 0.2), for Italy, (Germany, France) = (0.6, 0.4), for the Netherlands, (Germany, Belgium, UK, France) = (0.4, 0.2, 0.2, 0.2), for Brazil, (US, Argentina, Germany) = (0.53, 0.3, 0.17), for Chile, (US, Japan, UK) = (0.51, 0.26, 0.23), for Indonesia, (Japan, US, Korea) = (0.51, 0.35, 0.16), for Korea, (US, Japan) = (0.5, 0.5), for the Philippines, (US, Japan, Korea) = (0.54, 0.36, 0.14), and for Malaysia, (US, Japan) = (0.6, 0.4). For Canada and Mexico, the US is considered as a foreign country, while for Switzerland, Germany takes on the role due to the preeminent role of each country for each group.

  5. The results of the unit root test are available upon request.

  6. The sample periods are as follows: Australia (1976:Q1-2009:Q3), Brazil (1995:Q1-2009:Q4), Canada (1971:Q2-2009:Q3), Chile (1991:Q1-2009:Q3), Indonesia (1990:Q1-2009:Q3), Italy (1971:Q2-2009:Q3), Korea (1976:Q1-2009:Q3), Malaysia (1981:Q1-2009:Q1), Mexico (1981:Q1-2009:Q3), the Netherlands (1971:Q2-2009:Q3), the Philippines (1986:Q1-2007:Q4), Switzerland (1976:Q2-2009:Q3), and Spain (1976:Q2-2009:Q3).

  7. Kim and Ying (2001) also show that a change in the U.S. real GDP and the interest rates explains why there are more than 50 % of capital inflows into Korea and Mexico.

  8. The AIC selects 4 or less lags for all countries except Spain, Italy, and Korea, for which 5 lags are chosen.

  9. Due to the length of the paper, we only display the impulse responses of the capital account, the real output, and the current account in Australia, Switzerland, and Italy for developed countries in Figure 1 and the same variables in Brazil, Chile, and Indonesia for developing countries in Fig. 2. Full results are available upon request.

  10. Standard errors for the impulse responses and forecast error variance decompositions are computed using Monte Carlo simulations with 1000 iterations.

  11. Devaluation is the term that usually applies to exchange rate changes under a fixed exchange rate regime whereas part of the countries in this study maintained a floating exchange rate. We use devaluation and depreciation interchangeably.

  12. There is literature for capital control in Chile (Cowan and De Gregorio 2007) and Malaysia (Sharma 2003).

  13. The results are available upon request.

  14. Due to the length of the paper, the impulse responses from panel regressions for a capital inflow shock are not presented but are available upon request.

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Authors and Affiliations

  1. Department of Economics, California State University, Fresno, 5245 North Backer Ave, Fresno, CA, 93740, USA

    Gil Kim

  2. Department of Economics and Geography, Coggin College of Business, University of North Florida, 1 UNF Drive, Jacksonville, FL, 32224, USA

    Lian An

  3. Department of Economics, University of Kentucky, 335K Gatton College of Business and Economics, Lexington, KY, 40506-0034, USA

    Yoonbai Kim

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  1. Gil Kim
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  3. Yoonbai Kim
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Correspondence to Gil Kim.

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Kim, G., An, L. & Kim, Y. Exchange Rate, Capital Flow and Output: Developed versus Developing Economies. Atl Econ J 43, 195–207 (2015). https://doi.org/10.1007/s11293-015-9458-2

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