Exam 21: Capital Flows and the Developing Countries

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As described in Chapter 5, capital flows from the developed to the developing countries in search of a higher rate of return. In 2005, nearly $122 billion went from developed to developing countries. Of this total, $10 billion went to the low-income countries and nearly $147 billion went to middle-income countries. Most of this capital flow was in the form of FDI; $111 billion of FDI went from developed countries to the developing countries. The majority of the FDI ($261 billion) went to the middle-income countries. FDI to middle-income countries dominates the flow of capital from the developed to developing countries. The remainder of the capital flows is in the form of portfolio investment (bonds and equity).

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The World Bank makes loans to developing countries for specific infrastructure projects or loans designed to restructure the economy. Both types of lending are long run in nature. Originally, the IMF only made loans that were short run loans to provide temporary balance of payments support. However, the IMF has increasingly moved into lending to developing countries. Some of the newer forms of IMF lending are more linked to overall economic development and less specifically tied to balance of payments support. The result is that some forms of IMF lending now look suspiciously like some of the lending done by the World Bank.

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A commodity price shock occurs when there is a major change in the exchange rate caused by a change in the price of a primary commodity. If the price of a primary commodity decreases, this would decrease the supply of foreign exchange. In turn, this could trigger a major depreciation of the currency. This depreciation may result in a leftward shift of the aggregate supply curve that tends to increase the price level (P) and reduce real GDP (Y). A positive price shock also is possible. In this case, an increase in the price of a primary commodity may cause a rightward shift in the supply of foreign exchange. This shift would lead to a major appreciation of the currency. This appreciation may lead to a rightward shift in the aggregate supply curve. This shift of aggregate supply would decrease the price level (P) and increase real GDP (Y).