CAPITAL SHOCKS AS A SOURCE OF EXCHANGE RATE FLUCTUATIONS: ANALYSIS OF EMERGING MARKET ECONOMIES

Abstract

This paper uses structural VAR modeling, forecast error variance decomposition analysis, and impulse response function analysis to investigate the importance of demand, supply, money, and capital flow shocks as sources of fluctuations in the real exchange rate for seven emerging market economies (EMs) across different geographic regions in the periods after the adoption of inflation targeting. For South Korea and South Africa, a comparison is made between the sources of real exchange rate fluctuations before and after the adoption of inflation targeting. The methodology is modeled after Clarida and Gali’s (1994) work. The approach of long-run restrictions outlined by Blanchard and Quah (1989) is used to identify structural shocks to demand, supply, money, and capital flows. The study contributes to the existing literature in the following ways: first, it adds a capital flow shock to the original model estimated by Clarida and Gali as capital flows are of high importance in EMs; second, it makes use of more recent data and, in some cases, a wider period than was available in previous studies; third, it aims to examine any changes in the sources of exchange rate fluctuations in the period following the adoption of inflation targeting for countries with sufficient data pre- and post- inflation targeting. The key findings are that, for every country in the sample, demand shocks explain the majority of the variance in real exchange rate fluctuations. Capital flow shocks explain less than 10% of the RER variability across all horizons and countries.