Capital Flows and Real Exchange Rate Appreciation in Mexico

SummaryFollowing the recently-developed bounds testing approach, the paper analyzes the long-run determinants of the Mexican peso’s real exchange rate from 1988Q1 to 2008Q2. Controlling for the standard determinants, the paper shows that all types of capital inflows tended to appreciate the peso. In contrast to recent multi-country studies, it finds no evidence of a less harmful effect from foreign direct investment (FDI)—on the contrary, the FDI’s appreciation effect can be particularly strong—and interprets this finding. The paper also shows that monetary policy, through changes in the short-term interest differential, can have persistent, level effects on the real exchange rate.