Overshooting of Capital Inflows in Emerging EconomiesAlisher Saydalikhodjayev

21 April 2008

Inspiration

Recall Dornbusch overshooting model: Prices are sticky;Exchange rates overshoot their long-run level

Analogously, physical capital is “sticky” Change in stock is driven by a short-run

higher change in flow

Data (Bacchetta and van Wincoop, 1998)

High inflows relative to capital stock 1997 Financial Crisis?

India had capital controls

More Data

• Korea and Thailand: Overshooting* of capital inflows right before the financial crisis in 1997. Hmm…

• Mexico: Overshooting before the crisis in 1994. Whoa?!

* Relative to the long run steady state developed in Bacchetta and van Wincoop, 1998

Existing Frameworks

Foreign Capital Inflows (Bacchetta and van Wincoop, 1998)

Domestic Asset Price Bubbles (Ventura, 2002, Caballero and Krishnamurthy, 2005)

Key equations:

where f(τt) is decreasing in τt

Accumulation of capital stock is a function of tax rate on foreign investors, and differences in the mean and variance of the return on investment in emerging and developed countries.

Foreign Capital Inflows No intertemporal consumption decisions Agents in each country maximize risk-adjusted return from their

investment

Inflows change instantaneously in response to “liberalization” (basically, a reduction in the tax rate on foreigners), but adjust with time

Dynamics of overshooting

Domestic Asset Price Bubbles

What if international capital flows are not free? Asset price bubbles serve as a substitute Ventura (2002) uses the OLG model to show that

bubbles are a means for intertemporal trade Shift of resources from investment in low-efficiency

assets to consumption and some investment in high-efficiency assets

But, bubble volatility may reduce social welfare (Caballero and Krishnamurthy, 2005)

What about volatility of borrowing compared to volatility of capital stock?

Use a familiar two-period model Assume that world interest rate is a normally

distributed random variable Look at var(B2)

Basic Setup2

( , )r N r

( ) , 0CU C e

2

22(C )

22( )

C

EU C e

2

22

1(C )

21 2( ) ( )

C

ClU U C EU C e e

2

2 1 1 1 1 2

2 221 1 1 1

C (1 ) ( ) (1 ) ( )

( ( ) (1 ) )C

r F K C I K F K

F K C I K

2

2

2(C )2CM

Expected utility is just an integral of utility multiplied by its probability density function

Maximize:

s.t.

Similar to what we’ve done in class (12 Feb 2008)

Problem: solving the equation for first-period consumption is not easy

1( )

1

;C M dMe

dC where

Hopes To derive optimal first-period consumption and

investment To find the net borrowing position, B2

To analyze how shocks to the production function (factor productivity) or to world interest rate affect the variance of borrowing.

To expand to three periods:(long-run 1shock-overshootlong-run 2)

Critique, Help or Random Comments?