Increasing returns, financial capital mobility and real exchange rate dynamics

The late 1990s saw a US IT investment boom, large capital flows into the USA and an appreciation of the US$. At the time, this appeared to be driven by expectations of continued IT-related knowledge spillover externalities and associated productivity and profit growth. Using a two-region dynamic general equilibrium model with externalities, we find a once-off productivity shock leads to capital inflow and a real appreciation only in the short term. In the long term, capital flows stabilise and the real exchange rate depreciates. For a single shock to trigger long-term growth in capital flows requires unrealistically large externalities.