Perfect Capital Mobility: Impacts on the Economy

What’s it: Perfect capital mobility is a situation where capital is free to move in pursuit of higher returns. There are no barriers to capital in and out of a country or between uses, including exchange rate barriers.

Why is capital mobility important

Access to cheap funds. In global financial markets, mobility of capital provides access to a global pool of savings at lower interest rates. Companies or governments can raise funds cheaper on international financial markets by issuing global debt securities.

If the international interest rate is higher than the domestic interest rate, it will encourage capital inflows. Overseas investors are looking for higher returns. It increases demand and liquidity in the domestic financial market. Ultimately, that leads to lower interest rates and the cost of funds.

Higher returns. Higher returns. For capital owners, they can get high returns. It increases their income and welfare. They can invest anywhere without having to face risks such as exchange rates or capital flow constraints.

Productive use. If capital flows freely, it will likely move towards its best use. As a result, capital investment has become more efficient. Companies can raise capital at the lowest cost, encouraging them to increase their investment in capital goods and production capacity.

Fixed exchange rates and perfect capital mobility

Without political and macroeconomic risks, perfect mobility of capital is more likely under a fixed exchange rate regime. Because it doesn’t change, there is no exchange rate risk. As a result, the primary consideration for investing is the spread between interest rates (domestic vs. international).

Assume that interest rates on international financial markets are unchanged and at the same level as the domestic market. If the interest rate is domestic, it attracts foreign capital inflows. Foreign investors find the domestic market more attractive because it offers a higher rate of return. Because it is still, the exchange rate is not a problem.

Conversely, if domestic interest rates fall, it will cause investment to exit the domestic market. Investors are pursuing higher returns in overseas markets.

The effect of perfect capital mobility on the money supply

Under fixed exchange rates and perfect capital mobility, the international capital flow determines the domestic money supply. To understand this, let’s assume the previous assumptions hold. And, say, the central bank raises policy rates to cushion the high pressure of domestic inflation.

The increase in interest rates pushed foreign capital inflows. This resulted in increased demand for domestic currency and resulted in exchange rate appreciation.

Because the domestic economy adopts a fixed exchange rate system, appreciation requires the government (through the central bank) to intervene. To offset the high demand, the government increased the supply of domestic currency. As a result, the money supply increases.

An increase in the money supply promotes abundant liquidity in the economy. People are increasingly finding loans. Likewise, the bank has a lot of money to lend. This situation ultimately lowered interest rates on the domestic financial market.

If the spread is still positive (domestic interest rates minus international interest rates), foreign capital will still flow in. And that means the money supply still has to go up.

Such a situation continues until the interest rate is returned to its original level. Or in other words, domestic interest rates must be equivalent to international interest rates.

The effect of perfect capital mobility on monetary policy

Domestic monetary policy is not effective in influencing the domestic economy under fixed exchange rates and perfect capital flows. In the above example, external factors (foreign capital flows) produce the opposite effect against monetary policy’s initial objective.

Let’s summarize the effects of capital flows when central banks run monetary policies. Assume the central bank uses the policy rate to carry out monetary policy.

Under the expansionary policy, the central bank lowers the policy rate to increase the money supply. Meanwhile, under a contractionary policy, the central bank raises the policy rate to reduce the money supply.

Now, assume that international interest rates do not change. Thus, spreads are only affected by changes in domestic interest rates. Monetary policy becomes ineffective because:

• If the central bank cuts interest rates, the investment will exit the domestic market. The domestic exchange rate depreciates. To keep the exchange rate unchanged, it must step in by selling foreign currency to buy domestic currency. The supply of domestic currency in the economy is shrinking (now held mostly by central banks) and causes interest rates to rise.
• If the interest rate increases, foreign capital will flow in and cause the domestic currency’s appreciation. The central bank maintains the exchange rate unchanged by increasing domestic currency supply to offset foreign investment demand. Increasing the money supply will push domestic interest rates down.

Why is capital mobility imperfect

Perfect capital mobility is only a theoretical foundation and is challenging to achieve in the real world. Several reasons explain why that is.

First, at present, most countries do not adhere to fixed exchange rates. They adhere to a floating exchange rate, or at least a managed floating exchange rate. Therefore, exchange rates fluctuate rather than be fixed. That raises the exchange rate risk.

Exchange rate risk affects the rate of return on investment. Depreciation of the destination country’s currency reduces the return rate when investors translate the returns into their functional currency. Conversely, appreciation increases the rate of return.

Therefore, exchange rate risk is another consideration for investors before placing money in another country, not just interest rate spreads. The too volatile exchange rate is undesirable because it is less predictable and increases the uncertainty of returns.

Second, several countries have implemented capital flow controls. They do this to avoid the undesirable effects of capital inflows and outflows. They consider foreign investment flows, such as foreign portfolio investment, to be harmful to the economy. It only takes short term gains. It enters when the economy is prosperous and suddenly exits when the economy shows signs of weakness.

These inflows and outflows have a significant impact on the economy when they involve massive amounts. Exchange rates change drastically, increasing uncertainty, and jeopardizing economic stability. And it can lead to an exchange rate crisis.

Third, imperfect information related to investment opportunities abroad. Investing money in a foreign country is riskier than investing at home because we don’t have sufficient information.

Say an investor buys some stock in an overseas company. They must select several stocks to determine the most potential. Of course, their knowledge and ability to select stocks is no better than if they had bought shares in the domestic capital market. Long story short, imperfect information about returns and risks is another factor in making investment decisions, not only exchange rate and interest rate risks.

Fourth, monetary policy is ineffective. The central bank cannot influence the domestic economy and loses control over interest rates. Perfect capital flows require zero exchange rate risk. In other words, it operates under a fixed exchange rate. If the central bank raises policy interest rates, foreign capital inflows will drive interest rates down. Conversely, when the central bank reduces interest rates, capital outflows cause rates to rise.