Capital Flows, the Current Account, and the Real Exchange Rate: Consequences of Liberalization and Stabilization

This paper develops a dynamic framework in which macroeconomic liberalization and stabilization measures of the type recently seen in Latin America can be studied. The model is sufficiently general to cover both polar cases of a closed capital account and free private capital mobility, so the effects of liberalizing external asset trade can be studied. Capital-account liberalization leads to an initial period of real appreciation, but a long-run real depreciation; and the economy passes through alternating phases of boom and slump in the process. Devaluation is found to be nonneutral even in the long run and possibly contractionary in the short run. In contrast, a change in the rate of exchange depreciation is neutral, even with sticky prices, when capital is fully mobile. When capital is immobile, a disinflationary reduction inthe rate of exchange-rate crawl has effects that are the opposite of those arising from capital-account opening. The model suggests that capital-account liberalization, rather than disinflation, played a part in causing the massive real exchange-rate appreciation that accompanied recent Latin American programs of economic reform.