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Capital Inflows, Resource Reallocation and the Real Exchange Rate

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  • Emmanuel K. K. Lartey

Abstract

A large capital inflow to a developing economy can potentially cause a real exchange rate appreciation that is detrimental to the prospects of its tradable sector; a phenomenon known as the Dutch Disease. I analyse the effects of both the level and share of capital inflow on resource reallocation and real exchange rate movements in a small open economy. I find that there exists a trade-off between resource reallocation and the degree of real exchange rate appreciation. In particular, the less labour the tradable sector loses to the non-tradable sector, the greater is the real exchange rate appreciation. This result is driven by the share of investment accounted for by foreign capital, and suggests that an emerging market economy that adopts a production technique which utilizes a greater share of foreign capital relative to domestic capital will be more susceptible to the Dutch Disease following an increase in capital inflow. The results also imply that a policy designed to minimize real exchange rate appreciation during capital inflow episodes should encompass measures aimed at stabilizing prices of non-tradables. Copyright 2008 The Author. Journal compilation 2008 Blackwell Publishing Ltd

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Bibliographic Info

Article provided by Wiley Blackwell in its journal International Finance.

Volume (Year): 11 (2008)
Issue (Month): 2 (08)
Pages: 131-152

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Handle: RePEc:bla:intfin:v:11:y:2008:i:2:p:131-152

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Cited by:
  1. Acosta, Pablo A. & Lartey, Emmanuel K.K. & Mandelman, Federico S., 2009. "Remittances and the Dutch disease," Journal of International Economics, Elsevier, vol. 79(1), pages 102-116, September.
  2. Lartey, Emmanuel K.K., 2012. "Financial openness, nontradable inflation and optimal monetary policy," Economics Letters, Elsevier, vol. 117(3), pages 782-785.
  3. Emmanuel K. K. Lartey, 2011. "Financial Openness and the Dutch Disease," Review of Development Economics, Wiley Blackwell, vol. 15(3), pages 556-568, 08.
  4. Menon, Jayant, 2009. "Managing Success in Viet Nam: Macroeconomic Consequences of Large Capital Inflows with Limited Policy Tools," Working Papers on Regional Economic Integration 27, Asian Development Bank.

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