Boom‐and‐bust Cycles, External Imbalances and the Real Exchange Rate

• Published date: 01 January 2017
• Date: 01 January 2017
• Author: Nikolas A. Müller‐Plantenberg
• DOI: http://doi.org/10.1111/twec.12322

Boom-and-bust Cycles, External

Imbalances and the Real Exchange Rate

Nikolas A. Müller-Plantenberg

Faculty of Economics and Business Administration, Universidad Aut

onoma de Madrid,

Cantoblanco, Madrid, Spain

1. INTRODUCTION

DURING the last half-century, many countries have opened up their financial accou nts by

removing restrictions on cross-border capital flows. As a consequence, the volume of

international financial transactions and the associated stocks of foreign assets and liabilities

have increased substantially. Regardless of their economic benefits, capital flows can have

destabilising effects, particularly when they cause so-called boom-and-bust cycles. In the past,

there have been many episodes in all parts of the world in which countries experienced strong

capital inflows and rapid growth, yet subsequently had to endure serious economic recessions

and financial crises.

Boom-and-bust cycles share a number of common characteristics (Calvo et al., 1994, 1996,

2005; Conley and Maloney, 1995; McKinnon and Pill, 1996, 1997; Gourinchas et al., 2001;

Tornell and Westermann, 2002; Hern

andez and Landerretche, 2003, Aizenman and Jinjarak,

2009, Reinhart and Reinhart, 2009; Jord

a et al., 2011). The boom phase can be described as

follows. First, returns on real investment, whether actual or perceived, rise above the interna-

tional average. Often this is the result of changes in the country’s internal conditions –such

as, for example, domestic economic reforms, moves towards more financial openness, techno-

logical innovations or natural resource discoveries –that create an optimistic atmosphere and

make the country attractive in the eyes of foreign investors. However, in many cases external

factors play a role, too. Second, the country starts to receive large sums of foreign investment,

causing a boom in asset markets. Third, the country experiences accelerated growth and a

strong surge in domestic investment. Private consumption also rises, putting a brake on

national saving. Fourth, the current account, defined as the gap between saving and invest-

ment, deteriorates steadily. Fifth, despite the deficit on the current account, the real exchange

rate tends to appreciate strongly.

After reaching a peak, however, the country enters a downward spiral. First, domestic resi-

dents and foreign investors realise that their expectations were too optimistic, making stock

and real estate markets plummet. Second, foreign investors turn their back on the country,

I am grateful for the feedback I received from the participants of the 4th International IFABS Confer-

ence on ‘Rethinking Banking and Finance: Money, Markets and Models’ in Valencia, Spain, the 13th

Conference on International Economics in Granada, Spain, the Conference on ‘Intra-European Imbal-

ances, Global Imbalances, International Banking and International Financial Stability’ at Deutsches Insti-

tut f€

ur Wirtschaftsforschung (DIW) in Berlin and the 6th FIW Research Conference on International

Economics, held at the €

Osterreichische Nationalbank (OeNB) in Vienna and organised by the

Forschungsschwerpunkt Internationale Wirtschaft (FIW), the Institut f€

ur Ost- und S€

udosteuropaforschung

(IOS), the University of Ljubljana and the Hungarian Academy of Sciences (MTA KRTK). I also thank

Carmen D

ıaz Rold

an for her comments. A previous version of this paper was circulated under the title

‘Boom-and-bust cycles marked by capital inflows, current account deterioration and the rise and fall of

the real exchange rate’.

©2015 John Wiley & Sons Ltd

56

The World Economy (2017)

doi: 10.1111/twec.12322

The World Economy

pulling out their stakes. Third, the country enters recession and may also be confronted with a

financial crisis. Domestic investment falls, and so does consumption. Fourth, the current

account improves, not so much, however, as to undo the previous fall in the net foreign asset

position. Fifth and finally, the real exchange rate falls, often considerably below its original

level.

The described causes and effects of capital inflows are not unexpected. It is relatively

straightforward, for instance, to explain the first four features of each of the two respective

phases, the boom and the bust, using a model of intertemporal consumption and saving in an

open economy with capital mobility (see Calvo et al., 1996). However, this paper goes one

step further. While constructing a model that is capable to explain the main macroeconomic

fluctuations during temporary booms in foreign lending, it offers an entirely new theoretical

explanation of the fifth feature, the initial rise and subsequent decline of the real exchange

rate.

This paper is based on the simple, yet realistic notion that the nominal exchange rate

(defined here as the foreign-currency price of the domestic money) is driven by the demand

and supply conditions in the foreign exchange market. An excess supply of, say, the domestic

currency implies a low current exchange rate and thus an expected future appreciation, provid-

ing an incentive to hold that currency. An excess demand has the opposite effect. Through the

nominal exchange rate, the demand and supply conditions affect the real exchange rate, too.

The key question is why people hold certain amounts of different currencies. This paper

shows that the answer is straightforward as long as one avoids a very common economic fal-

lacy that affects much of the research and teaching in international finance. The balance of

payments is an accounting identity, meaning that the current account and the financial account

sum up to zero.

1

Many economists wrongly take this to mean that the current account, net

capital inflows and net sales of official reserves would also have to add up to zero. The truth

is that the sum of these three items generally differs from zero because a country’s financial

account does not only include capital flows and official reserve changes, but also monetary

payments.

Accepting that international payment flows exist and that they are important for exchange

rates implies the need to model the current account and capital flows independently. This is

what is done in this paper and what sets this paper apart from almost all theoretical models in

international macroeconomics since these models generally assume, explicitly or implicitly,

that capital flows follow the movements of the current account or vice versa.

This paper builds a model of optimal consumption and portfolio choice in an open econ-

omy. Among other assets, the representative consumer–investor holds money. However, the

amount of domestic and foreign money she or he holds depends on the accumulated money

flows between her or his country and the rest of the world –and thus on all present and past

current account balances, capital flows and reserve interventions. The model is used to study

the macroeconomic dynamics of a country whose investment returns initially rise and subse-

quently fall back to their original levels. It is shown how at the beginning capital inflows rise

and the current account deteriorates (the latter due to the boom in domestic consumption and

real investment) and how, later on, capital inflows slow down and the current account recov-

ers. For the exchange rate, the movements of the different balance of payments components

1

For simplicity, we ignore here the capital account, which records non-market and other special transac-

tions, as well as the errors and omissions category of the balance of payments.

©2015 John Wiley & Sons Ltd

LENDING BOOMS AND THE REAL EXCHANGE RATE 57

imply an appreciation during the upswing, followed by an even greater depreciation during

the downswing.

It is important to stress that boom-and-bust cycles such as those studied in this paper come

close to a natural experiment as they are associated with abnormally high returns on real and

financial assets. Whereas in tranquil times the current account and net capital outflows can

move in the same or different directions depending on the economic forces at work, the

model simulation of Section 4 and the case studies of Section 5 show that countries going

through boom-and-bust cycles experience simultaneous surges in real investment and in the

foreign demand for domestic equity. As a result, virtually all those countries face burgeoning

current account deficits and massive capital inflows. When there are no restrictions on the

financial account, capital inflows tend to exceed the deficit on current account initially, push-

ing up the currency. Yet since those inflows are of a temporary nature, sooner or later a slump

in the exchange rate becomes inevitable.

The paper is structured as follows: Section 2 reviews the literature. Section 3 presents the

model of optimal consumption and investment and explains how the nominal and real

exchange rates are determined by the movements of the balance of payments. Section 4 simu-

lates the behaviour of the model during a typical boom-and-bust cycle. Section 5 provides

case studies that show that the model can be applied to many different historical episodes.

Finally, Section 6 provides conclusions.

2. LITERATURE REVIEW

The theoretical model and empirical evidence of this paper are related to a number of

research areas. The literature on boom-and-bust cycles has already been cited in the introduc-

tion. Recent contributions that have linked exchange rate movements to balance of payments

fluctuations are those by Hau and Rey (2006) and M€

uller-Plantenberg (2006, 2010). One may

regard balance of payments flows as the origin of order flows in the foreign exchange market,

which the literature on foreign exchange (FX) market microstructure has shown to be strongly

correlated with exchange rate changes (Lyons, 2001). As regards the balance of payments

itself, the influential intertemporal approach to the current account holds that positive income

shocks lead to increased savings and current account surpluses (Obstfeld and Rogoff, 1995).

This paper shows, however, that the expansionary phase of boom-and-bust cycles tends to be

mostly investment-driven and thus associated with a massive deterioration of the current

account –the exact opposite of what the intertemporal approach to the current account sug-

gests. Finally, it should be noted that this paper offers an entirely new explanation for cur-

rency crises. Unlike traditional approaches, which identify fiscal deficits, domestic credit

growth or high unemployment as the fundamental causes of exchange rate crises (for a com-

prehensive review of the literature, see M€

uller-Plantenberg, 2015), this paper argues that cur-

rency crises are simply due to the drain of foreign exchange resulting from large and

protracted current account deficits.

3. MODEL

a. Theory, Definitions and Accounting Identities

In the model that is to be developed in this section, the exchange rate is essentially driven

by balance of payments flows. The key here is to model the current account and the financial

©2015 John Wiley & Sons Ltd

58 N. A. M€

ULLER-PLANTENBERG