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Capital Inflows, Resource Reallocation and the Real Exchange Rate

  • Emmanuel K. K. Lartey

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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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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  1. Brock, Philip L & Turnovsky, Stephen J, 1994. "The Dependent-Economy Model with Both Traded and Nontraded Capital Goods," Review of International Economics, Wiley Blackwell, vol. 2(3), pages 306-25, October.
  2. Reinhart, Carmen & Calvo, Guillermo & Leiderman, Leonardo, 1993. "“Capital Inflows and Real Exchange Rate Appreciation in Latin America: The Role of External Factors," MPRA Paper 7125, University Library of Munich, Germany.
  3. Mark Aguiar & Gita Gopinath, 2004. "Emerging market business cycles: the cycle is the trend," Working Papers 04-4, Federal Reserve Bank of Boston.
  4. Michael B. Devereux & Philip Lane, 2001. "Exchange Rates and Monetary Policy in Emerging Market Economies," CEG Working Papers 20017, Trinity College Dublin, Department of Economics.
  5. Guillermo A. Calvo & Leonardo Leiderman & Carmen M. Reinhart, 1996. "Inflows of Capital to Developing Countries in the 1990s," Journal of Economic Perspectives, American Economic Association, vol. 10(2), pages 123-139, Spring.
  6. Corden, W M, 1984. "Booming Sector and Dutch Disease Economics: Survey and Consolidation," Oxford Economic Papers, Oxford University Press, vol. 36(3), pages 359-80, November.
  7. Mark Gertler & Simon Gilchrist & Fabio M. Natalucci, 2007. "External Constraints on Monetary Policy and the Financial Accelerator," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(2-3), pages 295-330, 03.
  8. Reinhart, Carmen & Montiel, Peter, 2001. "The Dynamics of Capital Movements to Emerging Economies During the 1990s," MPRA Paper 7577, University Library of Munich, Germany.
  9. Kose, M. Ayhan & Riezman, Raymond, 2001. "Trade shocks and macroeconomic fluctuations in Africa," Journal of Development Economics, Elsevier, vol. 65(1), pages 55-80, June.
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  11. Corden, W Max & Neary, J Peter, 1982. "Booming Sector and De-Industrialisation in a Small Open Economy," Economic Journal, Royal Economic Society, vol. 92(368), pages 825-48, December.
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