International Capital Movements: Theory and Evidence

Abstract

In Chapter 2 the simple IS/LM paradigm was extended to incorporate the monetary effects of the balance of payments. While this paradigm, despite its many and well-known limitations, was found to be a useful general analytical framework, it is particularly weak in its representation of the theory of international capital movements. In particular, the notion of a stable F schedule implicitly assumes that: (i) capital flows in response to interest-rate levels; (ii) capital movements take place on an uncovered basis;¹ and (iii) domestic interest rates move independently of foreign interest rates so that a rise in the domestic rate induces a corresponding widening of the interest-rate differential against foreign assets. In this chapter we find that each of these assumptions is unwarranted both theoretically and empirically.