Real Exchange Rate Response to Capital Flows in Mexico: An Empirical Analysis

Abstract

After the 1980s, capital flows have accelerated in the less developed countries and since Salter’s seminal paper in 1959, it has been widely accepted that the real exchange rate respond to capital flows. Based on a simple model derived by Sjaastad and Manzur (1996) along the lines of Salter (1959) and Rodriguez (1994), we estimated the long-run response of the export (and true) real exchange rate to capital inflows in Mexico for the period 1970:1–97:4, and for the subperiods prior and after the trade liberalization and other structural reforms initiated in 1984. We have also examined the short-term dynamic properties of a system involving capital inflows, the external terms of trade, and the real exchange rate and found that the system is a stable, true error correction model, and that deviations from equilibrium due to exogenous shocks are corrected in about 14 quarters. The empirical findings suggest that there exists a long-run relationship between the ratio of capital inflows to GDP, the external terms of trade, and the export (and the true) real exchange rate.

Keywords: real exchange rate, capital inflows, external terms of trade

JEL Classification: F21, F31, F32