Capital inflows, external shocks, and the real exchange rate

This paper examines the effects of a fall in world interest rates on capital flows and the real exchange rate in an optimizing framework with imperfect capital markets. A permanent fall leads to a steady-state reduction in net foreign assets and a real depreciation, regardless of whether the country is initially a net creditor or net debtor. On impact, the real exchange rate appreciates in the net debtor case, but may either appreciate or depreciate in the net creditor case. The dynamics associated with a temporary shock depend not only on its duration but also on the initial asset position. (C) 1998 Elsevier Science Ltd. All rights reserved. JEL classifications: E44, F32, F34.