Do international capital flows smooth or transmit macroeconomic volatility? Time-series evidence from emerging markets

Capital flows—particularly of more volatile types of investment—have the potential to destabilize an emerging economy. On the other hand, economic theory suggests that financial integration provides channels by which macroeconomic volatility might be reduced. This study looks at four emerging economies to test which hypothesis is correct. Generalized impulse-response and variance decomposition analysis shows that the volatility of real consumption shows relatively little response to capital flows, but that FDI reduces output and investment volatility only in a few cases. Non-FDI flows have a stronger but ambiguous influence, reducing real investment volatility for Mexico and South Africa, but increasing it for Brazil and Russia.