Do Investors’ Net Purchases and Capital Retrenchment Activities Impact the Monetary Policy Response to Positive Inflation Shocks?

Abstract

First, we establish that the R/US$ exchange rate depreciation shocks lead to a transitory increase in a capital flow sudden stops episode, whereas the capital flow surges episodes decline. The R/US$ exchange rate depreciation also leads to domestic investors’ retrenchment. Hence, a stable exchange rate matters. Second, high inflation is a deterrent factor to capital inflows. Evidence suggests that inflationary shocks transitorily increase risk aversion, sudden stops episodes and a significant decline in net purchases of shares by non-residents. Therefore, stable inflation is important for domestic and non-resident investors’ activities. Evidence shows that sudden stops and VIX propagate the negative effects of high inflation in the GDP growth response. Furthermore, VIX and domestic investors’ capital flow retrenchment have a bigger impact in propagating inflationary pressures due to the R/US$ exchange rate depreciation shock. On the other hand, increased capital flow surges, retrenchment episodes and increased net purchases due to the appreciation in the R/US$ lower the inflation rate, thus leading to a lower level of the repo rate. Similarly, increased net purchases through the appreciation of the R/US$ exchange rate dampen the repo rate responses to positive inflation shocks.