Capital Flows, Reserves, and Exchange Rate Dynamics: Evidence From Emerging and Advanced Economies

ABSTRACT

While research on the real effective exchange rate (REER) has traditionally emphasised trade and policy channels, evidence on how disaggregated capital inflows and foreign exchange reserves shape REER dynamics remains mixed. Using panel data for 70 economies over 2001–2024, this study estimates two‐step system GMM models to examine how capital inflow composition affects the REER and then applies a dynamic panel threshold model to test whether the reserve buffer mechanism depends on financial development. The results show clear composition effects across inflow categories. Foreign direct investment is positively associated with REER appreciation mainly in developing economies, consistent with spending‐pressure and Dutch‐disease mechanisms. Foreign portfolio investment also exerts appreciation pressures across all samples, with larger effects in developing economies. By contrast, other investment is negatively associated with the REER in advanced economies and in the pooled sample but statistically weak in developing economies. The reserve results reveal a nonlinear, state‐dependent relationship, with reserves acting as a more effective buffer only above estimated financial‐development thresholds. Policy implications include managing capital inflow composition and calibrating reserve strategies to the level of financial development to safeguard external stability.