Capital Flows, Asset Prices and Output in Emerging Market Economies: A Theoretical Analysis

What is it about?

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 aggregate 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.

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Why is it important?

The first contribution 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 commodities 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. 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, unemployment arises due to wage indexation. We therefore, construct an open-economy model focusing on the link between capital flow and adjustments in the stock market.