Author: Ferreira Alex Luiz
Publisher: Routledge Ltd
ISSN: 1465-3486
Source: International Review of Applied Economics, Vol.21, Iss.1, 2007-01, pp. : 43-54
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Abstract
Contrary to the predictions of the theory underlying international finance, inflows of capital triggered by financial liberalisation have neither equalised real interest rates nor increased income growth in many emerging economies. We explain this puzzle by developing a model that combines the balance-of-payments constraint approach to economic growth with a less stringent version of the real interest rate parity hypothesis. The model's foundations are based on robust empirical findings or well-established macroeconomic models. We show that a perverse combination of income elasticities of demand for imports and exports generates slow income growth and high real interest rates. As domestic income grows and imports rise faster than exports, the real exchange rate is expected to depreciate in order to clear the balance of payments (or the foreign exchange rate market). An incipient capital outflow arises and interest rates increase. Faster adjustment in capital rather than in the goods market therefore generates a higher real interest rate differential between the domestic small open-economy and the rest of the world. The long run analysis shows that a constant degree of risk aversion implies a positive equilibrium real interest rate differential that affects economic growth. A permanent increase in default risk driven by persistent current account imbalances thus impacts on long run growth. The model's results are illustrated with evidence from the three major Latin America economies: Argentina, Brazil and Mexico.
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