INCREASING RETURNS, FINANCIAL CAPITAL MOBILITY AND REAL EXCHANGE RATE DYNAMICS

The 1990s appreciation of the US$ has been blamed on the 'irrational exuberance' of investors in the US IT boom. A core of these investors appeared to believe that technology-related productivity growth (due, in part, to knowledge spill-over externalities) would raise the relative US rate of return over a sustained period. This paper introduces a two country, dynamic general equilibrium model with international financial capital mobility and trade to investigate the conditions under which a single technology shock could cause such a sustained change in capital flows. We find that a once-off productivity shock, whether in the presence of (small-medium) externalities or not, leads to capital inflow and a real appreciation in the short term but is followed in the long term by a stabilisation of the capital account and a net depreciation of the real exchange rate. For a single shock to trigger long-term growth in relative capital returns appears to require unrealistically large externalities. The presence of adaptive expectations can lead to persistence and cyclical behaviour in the real exchange rate and current account.