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Capital Flows and Macroeconomic Policy in Emerging Economies

06/02/2003
Working Paper
Macroeconomics

This paper develops the proposition that capital flows must be given explicit consideration in macroeconomic policy making in emerging economies. If policy makers want capital inflows to be well-behaved (to be neither too scarce nor too plentiful; to be steady rather than volatile), it is not enough to run prudent fiscal and monetary policies. In fact, capital inflows can make the normal tasks of macroeconomic policy very difficult indeed. The conventional (or "Wall Street") view is that capital flows take care of themselves if macro policies are "correct". Here we develop an alternative paradigm (labeled the "structuralist" view) that assigns a high degree of exogeneity to capital flows. Since they are typically large and volatile, such flows can wreak havoc with macroeconomic policy.

The monetary impacts of inflows are difficult to sterilize, given their size and the tools available to the authorities in a typical developing country. Inflows almost always set off an unsustainable boom in output, consumption, and asset prices which is hard to resist. Through exchange rate appreciation, accumulation of debt, and persistent deficits in the current account of the balance of payments, they also sow the seeds for their subsequent reversal. Such reversals usually produce sharp and persistent declines in output, which in some cases can be catastrophic. Exchange rate expectations and the procyclical behavior of the fiscal accounts act as amplifiers of the cycle, both on the upswing and during the ensuing bust. The moral of the story is that, in emerging economies, policy makers need an additional tool: active management of capital inflows. This can take the form of a variable tax on inflows or outright capital controls, depending on the specific characteristics of the economy. The paper also argues in favor of intermediate exchange rate regimes, efforts to develop anticyclical fiscal policy tools, pragmatic monetary and exchange rate policies to deal with capital flight, and stronger international financial mechanisms to assist countries with capital booms and busts largely outside of their control.