Oxford OX 1 3 LA Working Paper Number 8 Short - Term Capital Flows , The Real Economy And Income Distribution In Developing Countries

The volatility of short-term capital flows (or ‘capital surges’) is now recognized as a major problem for macroeconomic management in developing countries; but the consequences for the ‘real’ economy that is, the behaviour of government, firms and households which subsequently translates into investment, growth, employment and welfare is less well understood. Short-term capital flow instability arises from the desire of investors to hold liquid assets in the face of uncertainty; affecting the real economy both through variations in both prices such as the interest rate and the exchange rate, and quantities such as levels of bank credit and government bond sales. In this chapter, government expenditure is shown to respond in an asymmetric manner to sudden changes in investor perceptions of fiscal solvency associated with portfolio capital surges. The impact of short flows on output and investment by firms through the availability of bank credit is also found to be large and asymmetric. The macroeconomic effect of capital surges on employment levels and the real wage rate is shown to arise from their influence on real exchange rates and domestic demand levels, although whether employment or wages adjust depends the monetary stabilization policy adopted. The chapter concludes with some implications of the analysis for longer-term growth and policy design.