Private Capital Movements and Exchange Rates in Developing Countries

The economic and financial literature of recent years has contained a considerable amount of discussion of the relationship between exchange rates and international differences in interest rates, on the one hand, and capital movements between the major industrial countries, on the other. Much less attention has been paid to the question of the effect of variations in exchange rates, or of the choice among alternative exchange rate systems, on private capital flows from industrial to developing countries. The present paper deals primarily with this relatively neglected topic. The principal question that will be considered is the following: how are private capital movements in any one country likely to respond to changes, or expected changes, in foreign exchange rates and in the country’s prices and costs, given the other factors which influence the incentive to invest in that country? Although the paper is chiefly concerned with flows of private capital to developing countries, the general analysis of the influence of changes in prices, costs and exchange rates on movements of various types of capital applies also to inter-national investment in industrial countries. The concluding section elaborates some implications of the analysis with regard to the broader question of the effect of alternative exchange rate systems (fixed or fluctuating exchange rates, unitary or multiple exchange rates) on capital flows.