Macroeconomic policy and capital flows

The recent dramatic rise in international capital flows is one of the most important issues currently facing developing countries. Although capital inflows permit higher investment and growth, large inflows have been associated with inflationary pressure, real exchange rate appreciation, and wide current account deficits. Information on the strength of the relationship between macroeconomic policy and capital flows is necessary to formulate an appropriate policy response to these concerns. Existing research, however, has paid scant attention to the role of domestic macroeconomic policies. This study analyzes the relationship between macroeconomic policy and capital flows from several viewpoints. The study first develops, from a theoretical basis, an empirical model to assess how capital flows constrain the conduct of monetary policy. Estimates of the model reveal the economic structure underlying the determination of domestic interest rates, and thus cast light on previous work on interest rate behavior in developing countries. The model is applied to data from Indonesia, and provides important results for monetary management there. The study next constructs, and estimates, a macroeconomic model of capital flows. This model demonstrates, for countries with pegged exchange rates, how macroeconomic policy contributes to capital flows. The empirical version shows that for Indonesia, monetary policy was a significant source of capital flows in practice. The empirical model also provides estimates of two key relationships: the degree to which capital flows offset monetary policy, and the degree to which monetary authorities sterilize capital flows. The third task of the study is to show that the exchange rate regime is a key determinant of the size and nature of capital flows. In particular, pegged exchange rates increase the sensitivity of capital flows to exogenous events, and may enhance the possibility of a crisis provoked by a rapid capital outflow--an outcome much feared by observers of the recent capital inflow episode. Although the econometric work of the study focuses on the illustrative case of Indonesia, the theoretical and empirical models developed here are appropriate for any country that pegs its exchange rate. The conclusions drawn from the Indonesian case may thus be of more general applicability.