Excess Capital Flows and the Burden of Inflation in Open Economies

Mihir A. Desai
James R. Hines Jr., University of Michigan Law School


Access to the world capital market provides economies with valuable borrowing and lending opportunities that are unavailable to closed economies. At the same time, openness to the rest of the world has the potential to exacerbate, or to attenuate, domestic economic distortions such as those introduced by taxation and inflation. This paper analyzes the efficiency costs of inflation-tax interactions in open economies. The results indicate that inflation's contribution to deadweight loss is typically far greater in open economies than it is in otherwise similar closed economies. This much higher deadweight burden of inflation is caused by the international capital flows that accompany inflation in open economies. Small percentage changes in international capital flows now represent large resource reallocations given two decades of rapid growth of net and gross capital flows in both developed and developing economies. For example, the net capital inflow into the United States grew from an average of 0.1 percent of GNP in 1970-72 to 3.0 percent of GNP in 1985-88. Gross capital flows have also expanded rapidly, as indicated by the growth of international loans from a stock of 5 percent of GNP in industrial countries in 1973 to 17 percent of GNP in 1989 (international Monetary Fund [IMF] 1991). Similarly, the ratio of the stock of foreign direct investment in the United States to U.S. GNP grew from 1.2 percent in 1972 to 7.4 percent in 1990 (Graham and Krugman 1991).