DP17661 Inflation and Capital Flows
Over the latest monetary policy tightening cycle, capital has been flowing from jurisdictions with the least aggressive hiking profiles to those with the most aggressive ones. This pattern of capital flows is consistent with the predictions of a standard open-economy model with nominal rigidities where cost-push shocks generate an inflationary episode and capital flows freely across countries. Yet, by raising demand for domestic non-tradable goods and services, capital inflows cause unwelcome upward pressure on firms' costs in countries most severely hit by these shocks. We argue that a reverse pattern of capital flows would have improved the output-inflation trade-off globally, hence requiring a less aggressive monetary tightening in the most severely hit countries and delivering overall welfare gains.