Interest rates and capital flows: An application of the Mundell-Fleming model in emerging markets

Abstract

Background: The Mundell-Fleming model (MFM) predicts that in an environment with freely floating exchange rates, a drop in interest rates will lead to capital flight. In other words, if the domestic interest rate is higher than the world interest rate, capital flows in. The model plays a key role in anticipating the link between interest rates and capital flows.
Aim: The core objective of this study was to test the applicability of the MFM in emerging market economies. Despite its importance, no study has examined the applicability of the MFM model in emerging market economies, as far as this study is aware.
Methods: A quantitative approach using panel annual data over the period of 2000 to 2017 for five emerging countries was carried out. Brazil, Malaysia, China, India and South Africa were the countries considered because of data availability. The dynamic ordinary least square (DOLS) and fully modified ordinary least square (FMOLS) were used to analyse the data.
Results: The study confirmed the applicability of the MFM, given a positive relationship between interest rate and portfolio investment.
Conclusion: The study recommended that to ease the threat of currency appreciation, the central banks in emerging market economies must ensure that the domestic interest rate aligns with the world interest rate. This will promote exchange rate stability, and whenever there is an appreciation or depreciation, the central banks must use interest rates to bring the exchange rate back to the desired rate.
Contribution: The results from the study can be used by the Central Banks to make effective monetary policy. The Central Banks in emerging market economies have been in a policy blind regarding how they should react to the changes in US interest rates. Understanding the applicability of Mundell-Fleming model in emerging market economies can be very powerful in helping the Central Banks and the government to make informed, educated, and unemotional foreign exchange decisions.