With current central bank interest rates at very low levels there is concern that these policies have been fueling credit and asset price booms in some emerging economies. However, potentially there could be significant fallout of the unwinding of these booms on developed nations.
How do Capital Flows impact on an economy?
When you have long periods of loose monetary policy (including low interest rates), like that in the US 0-0.25% – since September 11 2001 the US Federal Reserve has implemented a near zero rate policy which is now expected to last until 2014. According to Stanford University Professor John Taylor this results in the following:
1 Investors look elsewhere to gain higher returns and buy foreign securities and
2 Low interest rates encourage overseas firms to borrow in US dollars rather than in their domestic currency – US branch offices of foreign banks raised over $645 billion to make loans in overseas countries.
This flow of money means that the strength of the local currency starts to appreciate as foreign firms exchange their borrowed US$ and for the domestic currency. With this appreciation, the central bank becomes concerned with the affect the higher currency is having on the exchange rate and therefore export competitiveness.
The above is a brief extract from an article published in this month’s econoMAX – click below to subscribe to econoMAX the online magazine of Tutor2u. Each month there are 8 articles of around 600 words on current economic issues.