Boom-and-bust cycles marked by capital inflows, current account deterioration and a rise and fall of the real exchange rate

When the current account balance and net capital outflows do not exactly offset each other, net payment flows arise. Payment inflows into a country push the real exchange rate up, outflows push it down. This paper uses a model of optimal consumption and portfolio choice to determine the factors that drive international payment flows during boom-and-bust cycles. It shows that during such cycles, capital inflows first exceed the deficit on current account, strengthening the currency. Later on, when returns on domestic investments revert to their normal levels, the current account recovers, yet the overall decline of the international investment position provokes a fall of the real exchange rate even below its initial level. Case studies of countries experiencing rapid economic expansions followed by financial collapse confirm the paper’s theoretical predictions.