Capital Flows and Their Effects

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Capital flows, in simple terms, signify growth in the amount of money obtained from foreign or external sources for the acquisition of local capital assets including machines, estates or buildings. There can be various factors dominating capital inflows of any particular nation. These factors or reasons can be efficiently brought under three vast categories. These are as follows:

  • An autonomous rise in the domestic money demand
  • Growth in the domestic capital output
  • External influences, like plummeting international interest rates

About Capital Flows and their Effects

Guided by three main factors, capital flows can cause rise in asset prices. It can also influence the real and nominal exchange rates in a positive way. On looking at its impact on asset prices, we can discover three angles. The three dimensions are as mentioned below:

  1. International portfolio inflows can influence the assets’ demand in direct fashion. To say it so, capital flows into the stock exchange boost the demand for stocks and results in an increase of the stock price. Further, portfolio inflows can bear an impact on other markets. It can be pointed out that while capital flows into the stock exchange give rise to an increase in stock price, one still notices a decrease on stock returns. As a consequence, investors may look for other asset markets that bring higher returns.

  2. Capital flows may pave a way for rise in money supply and liquidity. As a result, asset prices may increase. As already pointed out that capital inflows usually pushes the real and nominal exchange rates, it is the responsibility of the monetary bodies to adopt such measures in the foreign exchange market that can check appreciation in exchange rates. They can tackle the situation of excessive demand for local currency by purchasing international currencies tracking such flows. This helps in accumulating foreign exchange reserves and at the same time domestic money supply. When this results in the rise of liquidity flows into asset markets, asset rates may increase. In this case, the intervention of the foreign exchange may be checked through selling government securities in open markets. Nevertheless, if foreign exchange intervention is sterilized only partially, it may lead to an increase in liquidity and asset prices.

  3. Capital flows are a potent cause of economic boom in a nation and result in a rise of asset prices. Capital flows subsequent to decrease in world interest rate can generate booms in consumption and investments.

Hence, it can be asserted without any doubt that capital flows and their effects hold great meaning in the financial condition of any nation.