Indeed, the perverse dynamics are as follows: high interest rate differentials induce capital inflows to arbitrage those differences; then policymakers strive to avoid the appreciation, which in general is thought to be transitory, since the sustainability of exchange rate management is limited; the incentives for inflows increase as not only the interest rate differential is large, but also the expectations of appreciation; finally, the appreciation takes place, which validates the expectations of arbitrageurs. This process goes for a while and may be accommodated gradually or ended by a sudden stop. In this process there are “excess” inflows and “excess appreciation”, and the issue is how to avoid those excesses. According to the simple dynamics I have just described a first line of defense to avoid excess fluctuations of capital flows is to maintain exchange rate flexibility. This prevents investors from speculating against an authority that will be defending the parity only transitorily. Moreover, by introducing volatility it increases the risks of a one sided bet on the exchange rate. An inflation commitment may also help to stabilize flows. As I discussed before, massive inflows that appreciate the currencies will result in a loosening of monetary policy that should reduce the incentives for carry trade. In contrast, if capital inflows generate a boom of activity, without inflationary consequences due to the appreciation of the currency, there could be the temptation to tighten monetary policy, aggravating the problem of massive inflows. To control expenditure without increasing pressures on the exchange rate, fiscal policy should help.
4  BIS Review 113/2009  To begin this discussion, I should emphasize that capital inflows to capital-scarce economies are a good thing. We know that capital flows to institutionally strong economies are beneficial (Prasad et al., 2002). Therefore, the role of policy is not to impede capital flows, but to avoid the creation of a bubble in domestic assets with consequences on resource allocation. 5 In this regard, to have in place sound prudential regulation during periods of abundance of capital is essential for financial stability, as we are reminded by the crisis in Chile in the early 1980s, the Mexican crisis of the mid-1990s, the Asian crisis, and more recently, the crisis in Eastern Europe. Even if one could accept that monetary tightening could be an appropriate response to combat an asset price bubble such as the recent housing price bubble, with all the caveats I discussed before, the problem is more acute in small open economies. Tightening monetary policy may have perverse effects, since it induces further capital inflows and strengthens the currency. In this case, the interest rate is not the most adequate instrument with which to burst the bubble.