International capital flows: implications for economic activity and monetary policy

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In the early 2000’s, there were large swings in capital flows across countries due to a worldwide savings glut. How did it affect investment across countries? Did it have an impact on the transmission channels of monetary policy? Chapter 1 develops a micro founded model of money and banking based on liquidity risk in which the government of a developing country mobilizes the savings of its citizens to lend to advanced countries. In this regard, the effects of monetary policy across countries can be meaningfully studied. Notably, the implications for investment in the developing country depend on its government’s commitment to lending to the advanced world. Furthermore, the increase in foreign capital to the advanced economy is complementary to domestic investment in the advanced economy. The effects of monetary policy also depend on the level of commitment by the government in the poor country. Despite recent improvements in the developing world, many developing countries still receive capital inflows from advanced countries. Chapter 2 shows that this is important as banks in advanced countries channel funds from domestic savers to entrepreneurs. Consequently, there are crowding out effects when the advanced country funds foreign debt. In turn, the effectiveness of monetary policy is exacerbated to reflect these crowding out effects. Further, there are adverse effects of monetary policy in the advanced country on capital formation in the developing country as external debt increases. Chapter 3 employs a sign-identified structural vector autoregressive (SVAR) model to analyze the effects of various types of official capital inflows to the United States on economic activity and the Federal Reserve. In particular, a positive shock to foreign official holdings of Treasuries reduces the size of the Federal Reserve's balance sheet and has a negative impact on business loans. Consequently, there is no significant impact on real estate loans and economic activity. Finally, a positive shock to foreign official holdings of corporate debt lowers the Fed funds rate, treasury yields regardless of maturity and has a significant impact on bank lending and economic activity due to a lack of response from the Federal Reserve.

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