Capital Inflows and the Real Exchange Rate: Analytical Framework and Econometric Evidence

WP/96/137-EA

.Capital Inflows and the Real Exdchange Rate: Analytical Framework
and Econometric Evidence. by Pierre-Richard Ag.nor and Alexander W. Hoffmaister


This paper examines the links between capital inflows and the real exchange
rate in a fixed (or predetermined) exchange rate regime. First, it discusses
two types of experiments: an increase in government spending on home goods, and
a reduction in world interest rates. The analysis suggests that a permanent
reduction in the world interest rate leads to a steady-state reduction in the
economy.s net stock of foreign assets and a real depreciation, regardless of
whether the country considered is initially a net creditor or a net debtor. On
impact, however, whereas the real exchange rate always appreciates in the net
debtor case, it may either appreciate or depreciate in the net creditor
case))depending on the relative strength of wealth and intertemporal
substitution effects.


The second part estimates a near-VAR model linking capital inflows, changes in
ex post interest rate differentials, government spending-output ratio, money
base velocity, and the temporary component of the real exchange rate (TCRER).
The model is estimated for Korea Mexico, the Phillippines, and Thailand.


Variance decompositions suggest that only a small percentage of the movements
of the temporary component of the real exchange rate is associated with shocks
to capital flows or the government spending ratio. Impulse response functions
indicate that a negative innovation in the (change in) world interest rates
leads to a capital inflow in all Asian countries, with little persistence over
time; a significant appreciation of the TCRER is observed in the Philippines
and Thailand, with some degree of persistence in both countries, whereas no
discernible effect can be detected in Mexico. In Korea, the TCRER depreciates
significantly in the second quarter after the shock. A positive innovation in
the government spending-output ratio has significant effects only in Korea,
leading to a reduction in capital inflows and a slight appreciation of the
TCRER.