Abstract
The workhorse open economy macromodel suggests that capital inflows are contractionary because they appreciate the currency and reduce net exports. Emerging market policy makers, however, believe that inflows lead to credit booms and rising output, and the evidence appears to go their way. To reconcile theory and reality, we extend the set of assets included in the Mundell–Fleming model to include both bonds and non-bonds. At a given policy rate, inflows may decrease the rate on non-bonds, reducing the cost of financial intermediation, potentially offsetting the contractionary impact of appreciation. We explore the implications theoretically and empirically and find support for the key predictions in the data.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
Notes
Symmetrically, using such a model, Paul Krugman argues in his Mundell–Fleming lecture (Krugman, 2014) that capital outflows are expansionary.
Another approach is to focus on the effect of the exchange rate itself on the financial system. To the extent that various actors, be it banks, firms, or households, have net foreign currency liabilities, an appreciation improves their balance sheet position. Banks can lend more, and firms and households can borrow more, both leading to an increase in domestic demand. This increase, in turn, may offset some or even all of the adverse effects of the appreciation on external demand. We leave this mechanism aside in our model and leave an assessment of the relative role of these two mechanisms to further research.
We have struggled with terminology, and “bonds” and “non-bonds” may not be ideal. Better but heavier terms would be “short-term bonds” and “non-short-term bonds”, as one can think of long-term bonds as imperfect substitutes for short-term bonds (and their return is not directly controlled by monetary policy) and thus part of “non-bonds.”
This is a conventional assumption, but it has implications later when we introduce sterilized FX intervention. Sterilized FX intervention can be defined either as an intervention which leaves the policy rate unchanged or an intervention which leaves the money stock unchanged. In general, if money demand depends not only on the policy rate but also on the other rates of return, the two will not be the same. With this specification, they are.
Our assumption that capital flows respond to a return differential but at a finite pace is rooted in vintage open economy models with imperfect asset substitutability (e.g., Kouri, 1976). Indeed, our portfolio model draws on Branson and others (1977), and Friedman (1978). While plausible, the demand functions are not derived from optimization. The justification is the usual one, simplicity of the resulting equations and solutions. (A recent paper by Gabaix and Maggiori (2015) presents, however, a micro-founded model where capital flows are channeled by financial intermediaries that must be compensated by the risk they hold when there are imbalances in the demand for financial assets, which generates similar demand functions to the ones assumed in this paper).
Note that, in specifying the capital account equilibrium condition, we ignore movements in the current account. Implicitly, we assume that the period we are looking at is short enough that we can ignore induced changes in the current account balance. A fully dynamic model would allow the current account to adjust over time. It would not, however, change the basic conclusions of the paper.
One could allow for sterilization to take the form of purchases or sales of domestic non-bonds. But this is typically not what central banks do when they sterilize, and does not yield particular insights.
Ostry and others (2012b) discuss further the role of foreign exchange market intervention as a tool for managing the exchange rate in the face of capital inflows.
There has been a clear evolution of views regarding the use capital controls, moving from the notion that they should typically be avoided to the notion that, together with other instruments, they can be appropriate tools to respond to capital inflows, e.g., Ostry and others (2010, 2011, 2012a) and IMF (2012).
A minor cheat: A change in R B changes the demand for money and thus requires a change in the money supply. This in turn leads to a change in wealth net of money demand W − M D and thus to a change in the demand for other assets for given rates of return. Given that money holdings are a small proportion of total wealth, we ignore this effect in the derivation below.
Existing empirical evidence suggests a positive correlation between domestic interest rates and inflows to EMEs, though the estimated correlations are not always significant and certainly weaker than the evidence for the effects on EME flows of low interest rates in advanced economies (Ghosh and others 2014).
Thus, within the logic of the model, FX intervention and the policy rate can insulate the economy in the same way as capital controls (a more optimistic conclusion, at least on paper, than the proposition by Rey (2013) that, short of using macroprudential tools or capital controls, countries cannot divorce themselves from global financial flows). They have, however, different implications for output. A higher policy rate has a direct adverse effect on output, and capital controls do not. Obviously, many caveats apply, but the logical point remains and is important.
This approach follows Blanchard and others (2015).
The adjusted-R 2 in the first stage is: 0.59 for bond flows and 0.68 for non-bond flows. When we separate the three types of non-bond flows, the first-stage adjusted-R 2 is: 0.60 for bond flows, 0.64 for FDI, 0.64 for portfolio equity, and 0.68 for other flows.
Changes in global monetary conditions are already captured in our estimates by the time fixed effects. If we were to drop the time fixed effects and include the US T-bill rate as an explanatory variable instead, that coefficient is not significant in the regressions where credit is the dependent variable. The effect of non-bond bond flows remains statistically significant with a point estimate of 0.5 for the specification analogous to Column 1 in Table 3, and the point estimate for other flows becomes even larger at 0.95 for the specification analogous to Column 2 in Table 3.
If we were to drop the time fixed effects and include the US T-bill rate as an explanatory variable instead, its coefficient is negative and significant in the regressions where GDP growth is the dependent variable. The point estimate is −0.19 and −0.16 in the specifications similar to the ones in Columns 3 and 4 (so all else equal, a 1 percent increase in the US T-bill rate would reduce growth by 0.16–0.19 percent). The results on the capital flows variables remain similar to the ones in Table 3.
The adjusted-R 2 in the first stage is: 0.67 for bond flows and 0.82 for non-bond flows. When we separate the three types of non-bond flows, the first-stage adjusted-R 2 is: 0.70 for bond flows, 0.79 for FDI, 0.81 for portfolio equity, and 0.82 for other flows.
We drop observations where the policy rate exceeds 20 percent to exclude high inflation outliers.
7
Note that financial derivatives are not included in neither the bond nor the non-bond flow variables.
References
Blanchard, O. 2007, “Current Account Deficits in Rich Countries,” IMF Staff Papers, Vol. 54, No. 2, pp. 191–219.
Blanchard, O., G. Adler, and I. de Carvalho Filho, 2015, “Can Foreign Exchange Intervention Stem Exchange Rate Pressures from Global Capital Flow Shocks?” NBER working paper 21427, July 2015.
Branson, W., H. Halttunen, and P. Masson, 1977, “Exchange Rates in the Short-Run: The Dollar-Deutschemark Rate” European Economic Review, Vol. 10, pp. 303–324.
Caballero, R. J., and G. Lorenzoni, 2014, “Persistent Appreciations and Overshooting: A Normative Analysis.” IMF Economic Review, Vol. 62, pp. 1–47.
Dornbusch, R., 1976, “Expectations and Exchange Rate Dynamics” Journal of Political Economy, Vol. 84, No. 6, pp. 1161–1176.
Farhi, E., and I. Werning, 2012, “Dealing with the Trilemma: Optimal Capital Controls with Fixed Exchange Rates.” NBER Working Paper w18199.
Farhi, E., and I. Werning, 2013, “A Theory of Macroprudential Policies in the Presence of Nominal Rigidities.” NBER Working Paper w18199.
Fleming, J. M., 1962, “Domestic Financial Policies Under Fixed and Floating Exchange Rates.” IMF Staff Papers Vol. 9, pp. 369–379.
Friedman, B., 1978, “Crowding Out or Crowding In? The Economic Consequences of Financing Government Deficits.” Brookings Papers on Economic Activity, Vol. 3, pp. 593–654.
Gabaix, X., and M. Maggiori, 2015, “International Liquidity and Exchange Rate Dynamics,” Quarterly Journal of Economics, Vol. 130, No. 3, pp. 1369–1420.
Ghosh, A. R., M. S. Qureshi, J. Kim, and J. Zalduendo, 2014, “Surges” Journal of International Economics, Vol. 92, pp. 266–285.
International Monetary Fund, 2012, “The Liberalization and Management of Capital Flows: An Institutional View.” http://www.imf.org/external/np/pp/eng/2012/111412.pdf.
Kouri, P., 1976. “Capital Flows and the Dynamics of the Exchange Rate.” Seminar Paper 67. Stockholm: Institute for International Economic Studies.
Krugman, P., 2014, “Currency Regimes, Capital Flows, and Crises.” IMF Economic Review, forthcoming.
Mundell, R., 1963, “Capital Mobility and Stabilization Policy Under Fixed and Flexible Exchange Rates,” Canadian Journal of Economics and Political Science, Vol. 29, pp. 475–85.
Ostry, J. D., A. R. Ghosh, K. Habermeier, M. Chamon, M. S. Qureshi, and D. Reinhart, 2010, “Capital Inflows: The Role of Controls.” IMF Staff Position Note No. 10/04.
Ostry, J. D., A. R. Ghosh, M. Chamon and M. S. Qureshi, 2011, “Capital Controls: When and Why?” IMF Economic Review Vol. 59, pp. 562–580.
Ostry, J. D., A. R. Ghosh, M. Chamon, and M. S. Qureshi, 2012a, “Tools for managing financial-stability risks from capital inflows.” Journal of International Economics, Vol. 88, No. 2, pp. 407–421.
Ostry, J. D., A. R. Ghosh, and M. Chamon, 2012b, “Two Targets, Two Instruments: Monetary and Exchange Rate Policies in Emerging Market Economies,” IMF Staff Discussion Note No. 12/1.
Reinhart, C., and V. Reinhart, 2009, “Capital Flow Bonanzas: An Encompassing View of the Past and Present.” NBER Macroeconomics Annual, University of Chicago Press.
Rey, H. 2013, “Dilemma Not Trilemma: The Global Financial Cycle and Monetary Policy Independence,” Jackson Hole 2013.
Author information
Authors and Affiliations
Corresponding author
Additional information
*Olivier Blanchard at Peterson Institute for International Economics, email address is: OBlanchard@PIIE.com. Jonathan D. Ostry, Atish R. Ghosh, and Marcos Chamon from the Research Department at International Monetary Fund, their email addresses are: jostry@imf.org, aghosh@imf.org, mchamon@imf.org. We are grateful to Charles Engel, Emanuel Farhi, Luca Fornaro, Jeffrey Frankel, Joe Gagnon, Pierre-Olivier Gourinchas, Sebnem Kalemli-Ozcan, Maurice Obstfeld, Mahvash Qureshi, and seminar participants at The Role of Central Banks in Modern Times: Twenty-Five Years into the Central Bank of Chile’s Independence Conference, the Central Bank of Brazil XVIII Inflation Targeting Seminar, and the Swiss National Bank, International Monetary Fund and IMF Economic Review Conference on Exchange Rates and External Adjustment for useful comments, and Eun Sung Jang, Anne Lalramnghakhleli Moses, and Chifundo Moya for excellent research assistance. The views expressed in this paper are those of the authors and do not necessarily represent those of the IMF, or its policies.
Electronic supplementary material
Below is the link to the electronic supplementary material.
Appendix
Appendix
The source for the capital flow variables is the IMF Financial Flow Analytics (FFA) database, whose underlying data primarily draw upon the IMF Balance of Payment Statistics Database, BPM version 6.
Flows are measured in gross terms (net purchases or sales of domestic assets by foreign residents).
Bond Flows: Balance of Payments, Financial account, Portfolio investment, Debt securities.
Equity Flows: Balance of Payments, Financial account, Portfolio investment, Equity and investment fund shares.
FDI Flows: Balance of Payments, Financial account, Direct investment.
Other Flows: Balance of Payments, Financial account, Other investment, Non-official sector.
Non-Bond Flows: FDI Flows + Equity Flows + Other Flows (as defined above).Footnote 21
Net Reserve Flows: Balance of Payments, Financial Account, Reserve Assets.
The capital flows are measured in current dollars and are scaled by the Nominal GDP in Dollars in that year.
Additional variables used: MSCI Equity Index, 10 Year Benchmark Government Bond Yield, and 1 Year Benchmark Government Bond Yield (from Bloomberg). GDP Volume (from International Financial Statistics, IFS). Partner Growth: Real GDP (2005 constant local currency prices) of partner countries weighted by export shares (from World Economic Outlook, WEO). Terms of Trade (from WEO). Domestic Credit to the Private Sector (from World Development Indicators). Policy Interest Rate (from IFS). For countries where the policy interest rate (or equivalent) is not available, we use the discount rate and where that is not available the money market rate.
Rights and permissions
About this article
Cite this article
Blanchard, O., Ostry, J.D., Ghosh, A.R. et al. Are Capital Inflows Expansionary or Contractionary? Theory, Policy Implications, and Some Evidence. IMF Econ Rev 65, 563–585 (2017). https://doi.org/10.1057/s41308-017-0039-z
Published:
Issue Date:
DOI: https://doi.org/10.1057/s41308-017-0039-z