Essays in Open Macroeconomics and Exchange Rates

In my thesis I study the effect of capital account policy with particular attention on real exchange rate and economic growth. The thesis is composed of two chapters, and each chapter deals with different dimensions of the policy.

In the first chapter, we document a new international stylized fact describing the relationship between real exchange rates and external asset holdings. Economists have long argued that the real exchange rate is associated with the net international investment position, appreciating as external wealth increases. This mechanism has been seen as central for international payments equilibrium and relative price adjustments. However, the effect of external assets held by the public sector—reserve accumulation—on real exchange rates may be quite different from that of privately held external assets, and that capital controls are a critical factor behind this difference. For 1975–2007, controlling for GDP per capita and the terms of trade, we find that a one percentage point increase in external assets relative to GDP (net of reserves) is related to an 0.24 percent real exchange rate appreciation. On the contrary, a one percentage point increase in reserve accumulation relative to GDP has virtually no effect on the real exchange rate in financially open countries (low capital controls), and is related to a 1.65 percent real exchange rate depreciation in financially closed countries (high capital controls). Results are stronger in developing countries and in more recent periods. Gross rather than net positions matter and a new theoretical model to account for the stylized fact is presented. The framework encompasses so-called precautionary and mercantilist motives for reserve accumulation, and also explains how the optimal capital account policy—the mix of reserve accumulation and capital controls—is determined. Further empirical support arises from evidence that reserve accumulation is associated with a trade surplus, along with higher GDP and TFP growth in countries with high capital controls, findings that are consistent with the mechanisms of our model.

In the second chapter, we examine the role of reserve accumulation in determining the effect of capital controls on economic growth. Using panel data of 42 countries during the period from 1989 to 2007, we find that capital controls combined with reserve accumulation—strategic capital account policy—contributes to the enhancement of labor productivity in tradable sectors and real GDP growth. While conventional wisdom emphasizes that capital account restriction is negatively related to economic growth, we show that the negative effect of closed capital account on the growth is reversed by large reserve hoardings. We also find that capital account policy leads to increases in employment in tradable goods sectors, which are workhorses for productivity growth.