Stagflation and Topsy-Turvy Capital Flows
Are unregulated capital flows excessive during a stagflation episode? We argue that they likely are, owing to a macroeconomic externality operating through the economy's supply side. Inflows raise domestic wages through a wealth effect on labor supply and cause unwelcome upward pressure on marginal costs in countries where monetary policy is trying to drive down costs to stabilize inflation. Yet, market forces are likely to generate such inflows. Optimal capital flow management instead requires net outflows, suggesting topsy-turvy capital flows following markup shocks.
For useful comments and suggestions, we thank Javier Bianchi, Saki Bigio, Luca Fornaro, Jordi Gali, Anton Korinek, Alberto Martin, Evi Pappa, Cedric Tille, and seminar participants at CREI, the Graduate Institute, the Universidad Carlos III de Madrid, the 2022 CEMLA-FRBNY-ECB conference and the BoF-CEPR conference on Monetary Policy in the Post-Pandemic Era. The views expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the Bank of Canada, the Federal Reserve Bank of Minneapolis, the Federal Reserve System, or the National Bureau of Economic Research.