Capital Flows and Macroeconomic Policies in Emerging Economies

Jan 2006
This study deals with the appropriate macroeconomic policies toward international capital flows. It argues that countries in a position to integrate themselves into world capital markets should develop specific policies to deal with capital flows. This paper first shows that foreign capital inflows are not only larger and more volatile but also that their effects on key macroeconomic variables are much stronger in emerging developing countries than in developed countries. Next, the two opposing paradigms regarding capital flows are discussed in detail. Then, a simple classical open economy macroeconomic model is presented as a benchmark against which to analyze the effects of unfettered capital flows. According to this model (which is the basis of conventional advice), there is nothing that policy makers need to do about capital flows, but to follow sound domestic macroeconomic policies. But once the key assumptions of the model are dropped, the effects of capital flows that one can observe in reality begin to emerge. Appropriate conclusions can then be derived.