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Endogenous inflows of speculative capital and the optimal currency appreciation path

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  • Mei Li
  • Junfeng Qiu

Abstract

This paper examines the optimal appreciation path of an undervalued currency in the presence of speculative capital inflows that are endogenously affected by the appreciation path. A central bank decides its appreciation policy based on three costs: (i) misalignment costs associated with the gap between the actual and long-run equilibrium exchange rates, (ii) short-term adjustment costs due to resource reallocation, and (iii) capital losses due to speculative capital inflows. Our model finds (1) when speculators face no liquidity shocks, the central bank tends to appreciate the currency quickly to discourage speculative capital; (2) when speculators face liquidity shocks, the central bank optimally pre-commits to a slower appreciation path, and the appreciation takes the longest time when the probability of liquidity shocks takes intermediate values; (3) the central bank tends to appreciate the currency more quickly when it conducts discretionary policy.

Suggested Citation

  • Mei Li & Junfeng Qiu, 2011. "Endogenous inflows of speculative capital and the optimal currency appreciation path," Canadian Journal of Economics, Canadian Economics Association, vol. 44(1), pages 364-379, February.
  • Handle: RePEc:cje:issued:v:44:y:2011:i:1:p:364-379
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    Cited by:

    1. Li, Mei & Qiu, Junfeng, 2013. "Speculative capital inflows, adaptive expectations, and the optimal renminbi appreciation policy," China Economic Review, Elsevier, vol. 25(C), pages 117-138.

    More about this item

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements

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