Capital Inflows, Inflation, and the Exchange Rate Volatility: An Investigation for Linear and Nonlinear Causal Linkages

Abstract

This paper empirically examines the effect of foreign capital inflows on domestic price levels, monetary expansion, and the exchange rate volatility for Pakistan using linear and nonlinear causality tests. The key message emerging from the analysis is that there is a significant inflationary impact of capital inflows, in particular during the period of surges in capital inflows. Specifically, we find evidence of a significant nonlinear Granger causality running from capital inflows to the change in domestic prices. We also show that domestic prices are nonlinearly caused (in Granger sense) by the growth of domestic debt and money supply-to-GDP ratio. Our results, however, suggest that the market interest rate and the nominal exchange rate do not have significant relationships with domestic prices. The findings suggest that there is a need to manage the capital inflows in such a way that they should neither create an inflationary pressure in the economy nor fuel the exchange rate volatility. JEL Classification: C22, C32, F21, F31, F32 Keywords: Capital Inflows, Inflationary Pressures, the Exchange Rate Volatility, Monetary Expansion, Nonlinear Dynamics