A FLOW OF FUNDS TEST OF THE CAPITAL INFLOW HYPOTHESIS

In this paper, we test the capital inflow hypothesis by estimating the stabilizing effect of induced net capital inflows on changes in nominal interest rates, regardless of the source of the exogenous shocks to credit markets, and second, by estimating the stabilizing effect of government-borrowing-induced net capital inflows alone. Estimates are based on dynamic simulations of a small econometric model of credit markets where interest rates are determined. U.S. quarterly data are used to estimate the model's parameters for the sample period from 1972:i to 1988:iv. The empirical results provide support for the capital inflow hypothesis, although not for the limiting case of an infinitely interest rate elastic supply of credit. In fact, induced net capital inflows have a significant stabilizing effect on changes in nominal interest rates.