Capital Flows and the Real Economy

Hamid Raza, Gylfi Zoega

Publikation: Bidrag til tidsskriftTidsskriftartikelForskningpeer review

Resumé

The effects of capital inflows on the real exchange rate and the growth of output, consumption and investment were explored using data from Iceland from the first quarter of 1997 to the last quarter of 2018. The objective was to explore whether capital inflows, caused by domestic interest rates being higher than foreign interest rates, were expansionary indicating the presence of an international financial cycle in contrast to the predictions of the Mundell-Fleming model. The statistical analysis consisted of the estimation of a vector autoregression system, which is used to generate impulse response functions for the variables of interest. We found that an increase in the capital inflow into a currency area increased output, consumption and investment. It follows that higher domestic interest rates under free capital mobility can have an expansionary effect by encouraging capital inflows that cause real exchange rates to increase as well as output and private expenditures. These findings call for the use of two policy instruments in small, open economies. In addition to interest rates, there is a need for some restrictions on portfolio investments by foreign investors. The restrictions will weaken the exchange rate effects of changes in domestic and foreign interest rates, leaving the interest rate channel of monetary policy to respond to the real economy.
OriginalsprogEngelsk
TidsskriftAtlantic Economic Journal
ISSN0197-4254
StatusE-pub ahead of print - 2019

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Interest rates
Capital flows
Capital inflows
Real exchange rate
Mundell-Fleming model
Policy instruments
Prediction
Exchange rates
Iceland
Statistical analysis
Impulse response function
Monetary policy
Currency area
Expenditure
Foreign investors
Portfolio investment
Vector autoregression
Capital mobility
Small open economy

Citer dette

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Capital Flows and the Real Economy. / Raza, Hamid; Zoega, Gylfi.

I: Atlantic Economic Journal, 2019.

Publikation: Bidrag til tidsskriftTidsskriftartikelForskningpeer review

TY - JOUR

T1 - Capital Flows and the Real Economy

AU - Raza, Hamid

AU - Zoega, Gylfi

PY - 2019

Y1 - 2019

N2 - The effects of capital inflows on the real exchange rate and the growth of output, consumption and investment were explored using data from Iceland from the first quarter of 1997 to the last quarter of 2018. The objective was to explore whether capital inflows, caused by domestic interest rates being higher than foreign interest rates, were expansionary indicating the presence of an international financial cycle in contrast to the predictions of the Mundell-Fleming model. The statistical analysis consisted of the estimation of a vector autoregression system, which is used to generate impulse response functions for the variables of interest. We found that an increase in the capital inflow into a currency area increased output, consumption and investment. It follows that higher domestic interest rates under free capital mobility can have an expansionary effect by encouraging capital inflows that cause real exchange rates to increase as well as output and private expenditures. These findings call for the use of two policy instruments in small, open economies. In addition to interest rates, there is a need for some restrictions on portfolio investments by foreign investors. The restrictions will weaken the exchange rate effects of changes in domestic and foreign interest rates, leaving the interest rate channel of monetary policy to respond to the real economy.

AB - The effects of capital inflows on the real exchange rate and the growth of output, consumption and investment were explored using data from Iceland from the first quarter of 1997 to the last quarter of 2018. The objective was to explore whether capital inflows, caused by domestic interest rates being higher than foreign interest rates, were expansionary indicating the presence of an international financial cycle in contrast to the predictions of the Mundell-Fleming model. The statistical analysis consisted of the estimation of a vector autoregression system, which is used to generate impulse response functions for the variables of interest. We found that an increase in the capital inflow into a currency area increased output, consumption and investment. It follows that higher domestic interest rates under free capital mobility can have an expansionary effect by encouraging capital inflows that cause real exchange rates to increase as well as output and private expenditures. These findings call for the use of two policy instruments in small, open economies. In addition to interest rates, there is a need for some restrictions on portfolio investments by foreign investors. The restrictions will weaken the exchange rate effects of changes in domestic and foreign interest rates, leaving the interest rate channel of monetary policy to respond to the real economy.

M3 - Journal article

JO - Atlantic Economic Journal

JF - Atlantic Economic Journal

SN - 0197-4254

ER -