Capital Flows and their Impact on the Real Effective Exchange Rate

Abstract

This paper analyzes the impact of capital inflows and the exchange rate regime on the real effective exchange rate. A wide range of developing countries (42 countries) is considered with estimation based on panel cointegration techniques. The results show that both public and private inflows cause the real effective exchange rate to appreciate. Among private inflows, portfolio investment has the biggest effect on appreciation, almost seven times that of foreign direct investment or bank loans, and private inflows have the smallest effect. Using a de facto measure of exchange rate flexibility, we find that a more flexible exchange rate helps to dampen appreciation of the real effective exchange rate caused by capital inflows.Private capital flows;real effective exchange rate;exchange rate flexibility;emerging markets;low-income countries;pooled mean group estimator