Capital mobility, real exchange rate appreciation, and asset price bubbles in emerging economies: a Post Keynesian macroeconomic model for a small open economy

The objective of this paper is to show that open economies that have (1) a high degree of capital mobility, (2) a low degree of organization in financial markets, and (3) a high sensibility of net exports to changes in the level of economic activity may have bubbles in asset prices if there is an exogenous shock to these economies that produces a real exchange rate appreciation. These are common features of emerging/developing economies such as Brazil and South Korea. In order to accomplish the objective of this paper, we will present a Post Keynesian macroeconomic model for small open economies that will take as a starting point, Taylor and O'Connell's (1985) model. After discussing the shortcomings of the original version of their model as an analytical framework for emerging economies, we will present a more general and relevant model that (1) has a broader list of assets (nine assets) than the original model (three assets); (2) assumes the existence of trade between the domestic economy and the rest of the world in order to introduce the crucial variable for our analysis--the real exchange rate; and (3) has high (although imperfect) capital mobility--in the sense of Mundell and Fleming--so that interest rate differential is a major factor determining capital inflows to emerging countries.