public budgets are hard to cut in the short run.
Under a floating-rate regime, a foreign capital inflow leads directly to an appreciation of the nominal and real exchange rates. The impact on output depends on the relative strengths of the increase in demand resulting from the capital inflow and the reduction in demand for domestic output because of the appreciation, but an increase in output is likely. If the exchange rate is allowed to adjust, the real appreciation attributable to the capital inflow has less effect on the domestic economy. Prices may rise, and interest rates may fall. However, for export-oriented economies a sustained appreciation may pose serious long-term problems for the export sector. Many fear that appreciation would cause significant loss of exports and eventually overall growth, as markets are lost to lower-cost competitors. Depending on the relative strengths of different effects, the expansion of domestic demand could be counteracted by either tighter fiscal policy or monetary contraction, offsetting some of the appreciation. The former still raises the same questions about the speed of response; the latter may raise interest rates enough to attract more foreign inflows, exacerbating the initial problem. Furthermore, exchange rate appreciation induced by capital inflows will increase the yield to foreign investors as measured in their own currencies, which may extend the capital inflows, particularly short-term, yield-sensitive flows. The ability of floating exchange rates to insulate an economy from external influences depends on the authorities 'willingness to accept exchange rate movements determined, in part, by foreign investment demand. A floating-rate regime also depends on the flexibility of domestic prices and wages and on adequate factor mobility to be effective. The prevailing fixed or managed exchange rate regimes in East Asia and most other countries indicate a marked reluctance to accept the implications of fully floating exchange rates.
Even at this simple level, the models illustrate several important points. The degree of openness of the capital account and the substitutability of foreign and domestic assets have an important bearing not only on financial sector policies but also on real sector policies. Financial flows can have tremendous effects on the real economy - for example, on interest and exchange rates and, through those variables, on output, employment, and trade. The more open an economy and he more integrated into world capital markets, the harder it is for the country to maintain interest rates that deviate significantly from world rates or an exchange rate that is far out of line with what markets believe to be proper. The market's views on these rates are driven by many short-and medium-term considerations and, particularly for interest rates by forces in the major financial markets. Market pressures on a given country's capital markets refle...
