## Are Capital Flows Expansionary or Contractionary? It Depends What Kind _IMF Blog, December 7, 2015_ ## Source details **Canonical URL:** [Are Capital Flows Expansionary or Contractionary? It Depends What Kind](https://www.imf.org/en/blogs/articles/2015/12/07/are-capital-flows-expansionary-or-contractionary-it-depends-what-kind) ## Other formats - [Markdown version](/en/blogs/articles/2015/12/07/are-capital-flows-expansionary-or-contractionary-it-depends-what-kind/index.md) - [Structured JSON version](/en/blogs/articles/2015/12/07/are-capital-flows-expansionary-or-contractionary-it-depends-what-kind/index.json) - [Bundle manifest](/en/blogs/articles/2015/12/07/are-capital-flows-expansionary-or-contractionary-it-depends-what-kind/bundle-manifest.json) ## Bibliographic details - Authors: Olivier Blanchard, Jonathan D Ostry, Marcos Chamon, Atish Rex Ghosh - Published: December 7, 2015 --- ### Overview - Authors: Olivier Blanchard, Jonathan D. Ostry, Marcos Chamon, Atish Rex Ghosh - Date: December 7, 2015 - Central question: Do capital inflows generally expand or contract economic activity in emerging markets? - Key empirical observation motivating the analysis: In typical emerging-market cases, capital inflows appear to be associated with currency appreciations, credit booms, and output increases (Ostry et al., 2012a). ### Theoretical reconciliation: bonds vs. non-bonds - Standard model implication: - Mundell-Fleming model suggests that, for a given monetary policy rate, inflows lead to an appreciation and thus to a contraction in net exports and a decrease in output. - Paul Krugman (2013) used a related model to argue that capital outflows are expansionary. - Extended-asset framework offered by the authors: - Distinguishes between “bonds” (policy-rate-type assets) and “non-bonds” (equities, bank liabilities—imperfect substitutes for bonds). - Capital inflows can lower the rate on non-bonds even if the policy rate is unchanged, reducing the cost of financial intermediation. - The positive domestic-demand effects from lower non-bond rates can offset adverse effects from currency appreciation. - Conclusion: Capital inflows may be expansionary even for a given policy rate; this reconciles the Mundell-Fleming intuition with policymakers’ observations. ### Role of foreign exchange market intervention - Sterilized FX intervention through bonds: - Can fully offset the effects of bond inflows, leaving both the exchange rate and interest rates unchanged. - Mechanism: central bank takes opposite position to foreigners—reduces demand for domestic bonds and increases holdings of foreign assets when foreigners increase demand for domestic bonds. - Sterilized intervention in response to non-bond inflows: - Can avoid currency appreciation, but only at the cost of a larger decrease in the rate of return on non-bonds (see Blanchard et al., 2015). ### Capital controls - Targeted capital controls alter the mix and effects of inflows: - Controls on bond inflows: - Reduce bond inflows. - Increase the effects of non-bond inflows on the exchange rate and on the rate of return on non-bonds. - Controls on non-bond inflows: - Magnify the effect of bond inflows on the exchange rate. - In both cases: - Targeted capital controls reduce upward pressure on the currency, which increases the “spillover” effects from the non-targeted inflow on the exchange rate, the rate of return, or both. ### Effects of monetary policy and the “policy dilemma” - Central bank objective choices (besides output/inflation mandate): - Stabilize the exchange rate → will lower the policy rate. - Stabilize the rate of return on non-bonds (limit credit expansion) → will increase the policy rate. - Policy dilemma framed: - Trade-off between stabilizing the exchange rate and limiting declines in non-bond returns. - False dilemma: - A combination of instruments (monetary policy + FX intervention) can, in principle, offset the effects of inflows on both the exchange rate and the rate of return to non-bonds without capital controls (see Ostry et al., 2012b). - This offers a more optimistic view than Rey (2013), who argued that, short of macroprudential tools or capital controls, countries cannot divorce themselves from global financial flows. ### Empirical evidence - Identification challenge: - Theoretical arguments concern effects of exogenous capital flows; empirical work requires instruments that affect inflows but are plausibly exogenous to domestic events. - Empirical analysis must control for countries’ policy tool usage that may offset flow effects. - Main empirical findings: - Bond inflows have a negative effect on economic activity. - Non-bond inflows have a significant and positive effect on economic activity. - Non-bond inflows (excluding FDI) have a strong positive effect on credit, much stronger than bond flows—highlighting the credit channel as key to output effects. ### Policy implications - Different nature of inflows requires different policy mixes: - Bond inflows: more likely contractionary for a given policy rate; sterilized intervention via bonds can neutralize effects on exchange rate and interest rates. - Non-bond inflows: can be expansionary by lowering non-bond rates and stimulating credit; sterilized intervention can prevent appreciation but may further depress non-bond returns. - Targeted capital controls change the relative pressures from different inflows and can amplify spillovers from the non-targeted inflow type. - Combining instruments—monetary policy, FX intervention, and, where appropriate, capital controls or macroprudential measures—allows policymakers to manage exchange-rate and credit-return trade-offs without accepting a strict dilemma. *Source: IMF blog post "Are Capital Flows Expansionary or Contractionary? It Depends What Kind" (December 7, 2015).* --- ## Content in this bundle - **14th Jacques Polak Annual Research Conference; November 7–8, 2013** - [14th Jacques Polak Annual Research Conference; November 7–8, 2013 (Markdown version)](/external/np/res/seminars/2013/arc/pdf/Krugman.pdf.md){rel="alternate" type="text/markdown"} - [14th Jacques Polak Annual Research Conference; November 7–8, 2013 (PDF)](/external/np/res/seminars/2013/arc/pdf/Krugman.pdf){rel="external" type="application/pdf"} - **Staff Discussion Note** - [Staff Discussion Note (Markdown version)](/external/pubs/ft/sdn/2012/sdn1201.pdf.md){rel="alternate" type="text/markdown"} - [Staff Discussion Note (PDF)](/external/pubs/ft/sdn/2012/sdn1201.pdf){rel="external" type="application/pdf"} --- ## References - [recent work](http://www.imf.org/external/pubs/cat/longres.aspx?sk=43360.0) _Source: https://www.imf.org/en/blogs/articles/2015/12/07/are-capital-flows-expansionary-or-contractionary-it-depends-what-kind_