Reserve accumulation and capital flows : theory and evidence from non- advanced economies

Abstract

Capital flows can have destabilizing effects in economies connected to the global financial system. Research has shown that external factors tend to explain most of these movements during episodes of financial turmoil, while country-specific determinants are able to explain heterogeneity throughout the recovery. This paper seeks to understand how reserve accumulations affect real and financial variables. For this purpose, a theoretical framework based on an extended version of the Mundell-Fleming model is presented and its predictions are tested with empirical evidence. Our results suggest that, under a flexible exchange rate regime, an accumulation of reserves generates net capital inflows with limited effects on the real economy. Specifically, we find that an accumulation of reserves of 1% of GDP would increase net capital flows about 0.81%.