Linda Goldberg and Michael Klein analyze the role of exchange rate changes for the pattern of direct investment flows and trade among Japan, the U.S., East Asia, and Latin America over the period 1978-93. They also find Japanese direct investment tended to stimulate East Asian imports from Japan, while U.S. direct investment substituted for U.S. imports from Asian countries. A more complete analysis of capital flows and exchange rates necessarily requires recognizing their simultaneous determination. With a small open economy model, Pierre-Richard Agenor and Alexander Hoffmaister analyze theoretically the responses of capital flows and the exchange rate to underlying shocks, such as a world interest rate decrease or a domestic fiscal stimulus. Using vector autoregressive empirical techniques, they find that world interest rate declines explain much of the pattern of capital inflows and real exchange rate appreciation observed in Asian countries.
Risk also plays an important role in international capital movements.
Theo Eicher and Stephen Turnovsky formulate a stochastic growth model to assess the effects of changes in risk associated with various external and domestic shocks on key macroeconomic variables. Their model explains the behavior of interest rates and exchange rates reasonably well, but does less well in explaining other variables, such as capital flows and output growth rates. Exchange rate crises and contagion Exchange rate crises are characterized by sudden, large outflows of capital that trigger devaluations, often spreading contagiously across countries. Economic theory suggests that a pegged exchange rate regime can become unviable when cross-border capital flows are freely mobile and market participants suspect that the government will not or cannot maintain the peg. For example, excessive monetary expansion to monetize fiscal deficits or bail out an insolvent domestic banking system can deplete the central bank's foreign exchange reserves and weaken its ability to defend a peg.