Capital Flows and the Real Economy

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.