Capital Flows, Asset Prices and Output in Emerging Market Economies
| Author | Sayan Baksi,Sayantan Bandhu Majumder,Ranjanendra Narayan Nag |
| Published date | 01 February 2015 |
| Date | 01 February 2015 |
| DOI | http://doi.org/10.1177/0015732514558138 |
| Subject Matter | Articles |
Capital Flows, Asset
Prices and Output
in Emerging Market
Economies:
A Theoretical Analysis
Ranjanendra Narayan Nag1
Sayan Baksi2
Sayantan Bandhu Majumder3
Abstract
In this article we construct a simple open-economy macro model to examine
how capital flows, monetary policy and dividend policies of firms influence asset
prices, economic activity and inflation. In this model, we consider a three-asset
framework based on domestic money, domestic equity and foreign bonds under
flexible exchange rate. The model is based on the assumptions of imperfect asset
substitutability and absence of sterilization. The model also incorporates an aggre-
gate supply function in the presence of wage indexation. The model can apply to a
large class of emerging market economies which have embarked on a programme
of liberalization of the financial sector in general and stock market in particular.
JEL: F31, F32, G12, E5
Keywords
Capital flow, exchange rates, stock market, Tobin’s q, monetary policy
Introduction
The liberalization of the capital account in the 1990s, brought about a gradual
change in the external sector dynamics of the emerging market economies.1
Studies reveal that surge in capital inflows since 1990s occurred mostly in the
Article
Foreign Trade Review
50(1) 1–20
©2015 Indian Institute of
Foreign Trade
SAGE Publications
sagepub.in/home.nav
DOI: 10.1177/0015732514558138
http://ftr.sagepub.com
Corresponding author:
Sayan Baksi, Deloitte Touché Tohmatsu India Private Limited, Kolkata 700091, India.
Email: baksisayan@gmail.com
1 Department of Economics, St. Xavier’s College, Kolkata, India.
2 Deloitte Touché Tohmatsu India Private Limited, Kolkata, India.
3 Department of Economics, University of Calcutta, Kolkata, India.
2 Foreign Trade Review 50(1)
private sector, while the official capital flows have gradually stagnated. In par-
ticular, private capital inflows can be essentially characterized by an increase in
portfolio investment.2 Portfolio flows are procyclical, not only in the context of
emerging market economies but also in case of advanced capitalist economies.
The impact of portfolio flows on intensifying boom and bust cycles is well known
(Edwards, 2001). Capital flows in the form of portfolio investments are highly
volatile, and thus, influence a large number of economic variables like exchange
rates, interest rates, foreign exchange reserves, domestic monetary conditions
along with savings and investments. Studies have shown that increase in capital
inflows have resulted in appreciation of real exchange rate, increase in asset
prices, such as, stock prices; increase in foreign reserves and monetary expan-
sion have also influenced consumption and production levels (Calvo et al., 1993;
Corbo et al., 1994; Khan & Reinhart, 1995). It has been observed that capital
inflows through the stock market have become very active since the 1990s.3 As
the share of foreign investment increases, the influence of foreign investors on
the stock price has substantially increased as well. Portfolio flows also render the
stock markets more volatile through increased linkages between local and foreign
financial markets. The importance of stock market in the general equilibrium of
the financial market has been duly recognized by Brainard and Tobin (1968) and
Tobin (1969). Also, the causal relation between stock market variables like stock
prices, market capitalization and the like with the real sector like real gross
domestic product, real consumption expenditures and real investment spending
has been well established in the literature (Baumol, 1965; Bosworth, 1975). For
instance, the relation between stock prices and real consumption expenditures is
based on the life cycle hypothesis of Ando and Modigliani (1963).4 Similarly,
stock prices are linked to investment spending based on the q-theory of James
Tobin.5 Classical economic theory also suggests a relationship between stock
market performance and exchange rate behaviour. For instance, Dornbush and
Fisher (1980) affirm that currency movements influence international competi-
tiveness and balance of trade position, and consequently the real output of the
economy. This in turn affects current and future cash flows of firms and their
stock prices.
Our model is based on Blanchard (1981). For clarity, it is worth describing
the contributions of this article relative to Blanchard and explaining why the
results here may differ from those generated by Blanchard. The first contribu-
tion of this article is that it extends Blanchard (1981) to an open economy set-up.
The economy that we consider in our model is open to both trade in commodi-
ties and financial assets. We incorporate a three-asset framework in our model,
comprising of domestic money, domestic stock (shares) and foreign bonds. One
central assumption underlying our model lies in the imperfect substitutability
between stocks and bonds.6 This is characterized by the existence of a risk pre-
mium between the return on domestic equity and the return on foreign bonds. The
exchange rate is considered to be flexible. The second contribution of this article is
that the supply side aspects of employment are considered in this article. The
Blanchard paper is based on Keynesian unemployment, while in this article, unem-
ployment arises due to wage indexation. We therefore, construct an open-economy
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