Capital inflows, Dutch disease effects, and monetary policy

Thesis advisor: Fabio GhironiThesis advisor: Peter N. IrelandThis dissertation consists of three essays on Dutch disease effects of capital inflows in emerging market economies. In chapter one, I develop a twosector dynamic, stochastic, general equilibrium model of a small open economy, incorporating an investment technology that utilizes both domestic and foreign capital, and show that as capital inflow increases, tradable sector output increases initially but later contracts as output of the nontradable sector expands in response to an increase in consumption of nontradables. The increase in nontradables consumption causes the relative price of nontradables to rise, thereby exerting pressure on the real exchange rate to appreciate. The model is consistent with features of the business cycle in emerging market economies that were recipients of capital inflows. Chapter two investigates the question of whether capital inflows cause the real exchange rate to appreciate, and whether different forms of capital inflow have variable effects on the real exchange rate. I use panel data for a group of sub-Saharan African countries to estimate a dynamic real exchange rate model specifying a set of capital inflow variables. The results reveal that increases in foreign direct investment and, especially official aid cause the real exchange rate to appreciate. Chapter three develops a monetary version of the model in the first chapter, with monopolistic competition and sticky prices in the nontradable sector. I examine the roles and welfare implications of a set of monetary policy rules in a small open economy that is susceptible to the Dutch disease. The results show that Dutch disease effects occur under a fixed nominal exchange rate regime, mimicking the dynamics in economies that pegged the nominal exchange rate during episodes of capital inflow; whereas Taylor-type interest rate rules featuring either the real exchange rate or the nominal exchange rate avert Dutch disease effects. Welfare results reveal that the optimal rule is a generalized Taylor rule consistent with nominal exchange rate flexibility.Thesis (PhD) — Boston College, 2006.Submitted to: Boston College. Graduate School of Arts and Sciences.Discipline: Economics