Capital inflows, financial intermediation, and aggregate demand

In trying to explain the balance-of-payments and banking crises of 1994-95 that erupted in Mexico, observers have pointed to various effects of the substantial capital inflows that took place in the preceding half decade. It has been argued that these inflows contributed to rapid monetary growth, real appreciation of the peso, and the widening of Mexico's current account deficit. In addition, by making available credit for consumption loans at a time when investment spending in Mexico was not yet ready to grow rapidly, these inflows may have contributed to the fall in Mexico's savings rate. ; This paper looks at the effect of capital flows on macroeconomic and financial variables in Mexico during the 1980s and 1990s and compares Mexico's experience with that of a cross-section of Pacific Basin countries. In particular, we attempt to gauge the effect of capital flows on money growth, interest rates, consumption, and investment. We do find evidence of an independent effect of capital flows on monetary conditions and domestic demand, controlling for certain other domestic factors. However, these inflows appear not to have altered substantially the basic trajectories of money, consumption, and investment in the recipient countries.