December 7, 2015/iMFdirect

by Messrs. Blanchard, Ostry, Ghosh, and Chamon

With the expected move by the Federal Reserve to raise interest rates before the end of the year, many are asking about the effects on emerging market countries. Will outflows increase, and how will this affect economic activity in emerging markets? To answer that, we need to know if capital inflows are in general expansionary or contractionary.

One would think that the question was settled long ago. But, in fact, it is not. It is a case where theory suggests one thing and practice another. The workhorse model of international macro (the Mundell-Fleming model), for example, 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. Only if the policy rate is decreased sufficiently can capital inflows be expansionary. Symmetrically, using a model along these lines, Paul Krugman argued in his 2013 Mundell-Fleming lecture that capital outflows are expansionary.

Emerging-market policy makers, however, have a completely different view. They see capital inflows as leading to increases in credit and output unless they are offset by an increase in the policy rate. The evidence appears to support the perception of policy makers. In the typical emerging market case, capital inflows appear to be associated with currency appreciations, credit booms, and output increases (Ostry et al., 2012a).

What is true in practice can also be true in a model

 How can we reconcile the models and reality? The answer we offer in some recent work relies on extending the set of assets in the economic model, by allowing for both “bonds” (the rate on which can be thought of as the policy rate) and “non-bonds,” i.e., assets such as equities and bank liabilities which are imperfect substitutes for bonds. In this case, even if the policy rate—which we take to be the rate on bonds—is given, capital inflows may decrease the rate on non-bonds and reduce the cost of financial intermediation. The positive effect of these lower rates on domestic demand may then offset the adverse effects of currency appreciation on external demand. Capital inflows may in this case be expansionary even for a given policy rate. There is thus a tentative reconciliation between the Mundell-Fleming model and policy makers’ views.