Ebook Capital Inflows, Dutch Disease Effects and Monetary Policy in a Small Open Economy
“The analysis of the paper has been conducted subject to many limiting assumptions, including a concern with real and not nominal magnitudes, absence of international capital mobility...the key distinction between the resource movement effect and the spending effect of the boom would remain important ingredients in a more complete analysis of the issues arising from the ‘Dutch disease’...We have also not touched on the issue of whether a deliberate policy of preventing a real appreciation... should be pursued.” W.M. Corden and J.P. Neary, Economic Journal (1982), p 841.
The documented experiences of the largest recipients of capital inflows in Asia and Latin America include high investment and consumption, gross domestic product (GDP) growth, increased current account deficits and real exchange rate appreciation. Capital inflows have therefore been both beneficial and problematic. Thus, despite their long-term benefits in increased efficiency in investment and associated technology transfers and economic growth, capital inflows raised serious concerns among policy makers because of their potential effects on macroeconomic stability, the competitiveness of the export sector and the external viability of the recipient countries. The most popular policy response to capital inflows in both Latin America and Asia was sterilization, with the aim to mitigate inflationary pressures and appreciation of the real exchange rate.
One aspect of capital inflow dynamics that has received little attention in the literature is its potential to induce resource reallocation, which is symptomatic of the Dutch disease. In fact, there was an expansion in nontradable output as a share of GDP and a decline in the production of manufactured goods as a share of GDP in both Argentina and Philippines during the peak inflow period of 1990-1994, the changes being more pronounced in Argentina than in Philippines. As the above stylized fact on monetary and exchange rate policy during episodes of capital inflow suggest, addressing the resource reallocation effect and the associated impact on the prices of nontradables were not a direct focus of policy objectives. More recent years have witnessed the integration of poor developing countries into the global economy accompanied by a surge in private capital inflows into these economies. This recent wave of private capital inflows could potentially lead to the realization of the Dutch disease in poor developing countries, and therefore exposes them to policy challenges similar to those that confronted middle income countries in the 1990s with respect to reconciling international capital mobility and domestic macroeconomic stability.
This paper examines the question of whether Dutch disease effects in the form of contracting manufacturing sector and rising nontradable prices, caused by capital inflows, should be addressed by monetary policy. I develop a two-sector small open economy model with sticky nontradable prices to analyze the effects of an increase in capital inflow on resource reallocation and real exchange rate movement under alternative monetary policy rules, and address the fundamental issue of whether monetary policy has any desirable properties in such an economy. A fixed exchange rate regime which captures the policy stance in Latin America and Asia during episodes of capital inflows serves as the benchmark rule against which other alternatives are compared in terms of model dynamics. The alternative policy rules are formulated such that the policy maker follows a generalized Taylor rule in which deviations of nontradable price inflation, GDP and either nominal exchange rate depreciation or real exchange rate depreciation from the steady state feed back into the interest rate. These represent the scenerio where the monetary authority is not only concerned with real appreciation via nominal exchange rate but also increasing prices of nontradables.
The results show that an increase in capital inflow causes Dutch disease effects when monetary policy is designed to keep the nominal exchange rate fixed whereas when monetary policy follows a generalized Taylor interest rate rule featuring either the nominal exchange rate or the real exchange rate, Dutch disease effects do not occur. The differences in dynamics emanate from the variable impact of monetary policy on investment decisions. Welfare results also reveal that the optimal rule is a generalized Taylor-type rule consistent with nominal exchange rate flexibility, under which Dutch disease effects do not occur. The underlying intuition is that flexibility in the nominal exchange rate is necessary to generate optimal movements in international relative prices in response to exogenous shocks when prices are sticky, which in turn leads to optimal responses in the household’s consumption and labor supply.
Theoretical analyses of Dutch disease effects of capital inflow in developing economies have largely been within a partial equilibrium framework, and have mostly been based on the dependent economy model. There is a rather limited number of studies that have examined foreign capital dynamics in small open economies within a general equilibrium framework, none of which has analyzed the link between capital inflows and Dutch disease effects. The existing contributions to this area of research have generally studied issues relating to real exchange rate fluctuations and current account dynamics. Examples of such studies include Serven (1995), Agenor (1998) and Gopinath (2000). In general, these studies make no reference to the Dutch disease effects of capital inflows. This paper therefore contributes to the literature by examining Dutch disease effects of an increase in capital inflows to a small open economy, with a discussion on the role and welfare effects of monetary policy. and welfare effects of monetary policy.
The rest of the paper is organized as follows. Section 2 presents the details of the model. Section 3 describes the solution and calibration of the model. Section 4 presents an analysis of the dynamics of the model under alternative policy rules and section 5 discusses quantitative implications of the model. Section 6 analyzes the welfare implications of monetary policy and concluding remarks are given in section 7.
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