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The impact of capital flow reversal shocks in South Africa- a stock- and flow-consistent analysis

Konstantin Makrelov, Rob Davies and Laurence Harris

No 9392, Working Papers from South African Reserve Bank

Abstract: South Africa’s economy has a very well-developed financial sector and high reliance on capital flows. We employ a micro-founded and stock- and flow-consistent model in the tradition of Backus et al. (1980) to study the impact of capital flow reversal shocks on the South African economy. The model provides for a richer representation of institutional balance sheets than existing models do. The financial sector’s behaviour in the model draws on the recent theoretical frameworks of Borio and Zhu (2012) and Woodford (2010), which highlight the relationship between bank capital, the risk-taking behaviour of the financial sector, lending spreads and economic activity. We specify a dynamic adjustment model of household expectations with properties that differ from the way in which expectations are formed in both stock- and flow-consistent as well as dynamic stochastic general equilibrium (DSGE) models. Household expectations resemble bounded rationality. The financial accelerator mechanism operates through the balance sheets of all institutions in the economy. The results indicate larger impacts compared to previous studies. We find that, even in the absence of large foreign currency-denominated liabilities, a reversal in capital flows can affect the domestic economy through its impact on domestic liquidity, on the risk-taking behaviour of the financial sector, and on the demand for assets. The negative effect can be exacerbated if the shock changes the expectation formation process of agents.

Date: 2019-07-19
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