Institutional investors and emerging markets with intermediate exchange rate regimes: A stock-flow consistent model

This paper develops a two-country stock-flow consistent model to analyse the relationship between advanced and emerging countries. The relationship between the two countries is asymmetric: advanced countries are characterised by an institutional investors’ sector which invests in both domestic and emerging markets assets, whereas emerging markets own advanced countries assets as a result of foreign exchange reserves accumulation by their central bank. The paper aims to show how the portfolio choice of institutional investors, which have return requirements to meet, is the key driver of financial stability in emerging markets, particularly by determining the dynamics of the exchange rates of emerging markets economies. Their role, compared to a standard open-economy model may be stabilising or de-stabilising, depending on the nature of the shock that induces changes in portfolio choices. The paper also shows how “intermediate” exchange rate regimes, as commonly found nowadays in the practice of emerging markets central banks, may be succesful at containing such instabilities.