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Context: I was watching a video about Venezuela, and, it all started with capital flight due to poor confidence in the government. The government tried to stop it, and in the process it created a bubble in the exchange market, causing smuggling and exportation into neighboring countries highly profitable in order to buy the dollar outside Venezuela and to sell at high prices in the bubble inside Venezuela. I can see how that causes inflation (same money supply chasing less domestic goods).

But then, the video said: if the foreign exchange market is open in order to end the bubble once and for all, allowing the currency to depreciate to its normal levels, thus allowing capital flight to happen in the first place, it would trigger more and more inflation (in hyper levels). And that's when I bugged me. I started searching in other sources, for instance this one, and several of them said that capital flight can indeed trigger inflation. But why?

Let's focus on capital flight: It is my understanding, that capital flight shifts the supply curve of a given currency in the exchange market, causing its depreciation with respect to, say, the dollar. But then.....:

(1) Shouldn't it cause a deflation? Currency is less and less available (due to flight) for the purchase of domestic goods, thus.. deflation. That is, a smaller amount of currency chasing the same goods.

(2) But also, capital flight is done with saved money, instead of money reserved for purchases, and that means aggregate demand is not affected much, meaning, purchases are done as normal, and normal life follows. Surely, that doesn't mean a deflation, but it doesn't mean an inflation either.

(3) Consider this: Assume for whatever reason, interest rates has fallen. This means, borrowing money is cheaper, and that is likely to cause a shift in aggregate demand and domestic consumption, possibly boosting the economy, and causing some inflation in the process. However, with capital flight, there's less and less investment done inside the nation, so, the supply of investment shifts, causing an increase of interest rates -- which again, should tend to cause a deflation due to a decrease in the money supply (basically, the reverse reasoning of lower interest rates).

My question: Why does capital flight can trigger inflation? What is wrong with my reasoning in these three situations?

I am not an economist.. so... forgive me if this is such a simple question.

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(1) Shouldn't it cause a deflation? Currency is less and less available (due to flight) for the purchase of domestic goods, thus.. deflation. That is, a smaller amount of currency chasing the same goods.

The dollar is less available, whereas the purchase power of the bolivar (Venezuela's domestic currency, apropos of your example) becomes negligible: To buy the same goods, today Venezuelans need more bolivars than in the past. Inflation comprises two factors: economic activity and purchase power. In cases like this, inflation is driven up by the bolivar's drastic loss of purchase power.

(2) But also, capital flight is done with saved money, instead of money reserved for purchases, and that means aggregate demand is not affected much, meaning, purchases are done as normal, and normal life follows. Surely, that doesn't mean a deflation, but it doesn't mean an inflation either.

Capital flight results in a reduction of supply. If demand remains unchanged, then the intersection of supply and demand curves occurs at a higher equilibrium price. That means that the bolivar has lost purchase power.

(3) Consider this: Assume for whatever reason, interest rates has fallen. This means, borrowing money is cheaper, and that is likely to cause a shift in aggregate demand and domestic consumption, possibly boosting the economy, and causing some inflation in the process. However, with capital flight, there's less and less investment done inside the nation, so, the supply of investment shifts, causing an increase of interest rates -- which again, should tend to cause a deflation due to a decrease in the money supply (basically, the reverse reasoning of lower interest rates).

It is difficult to make conjectures where a situation gets out of control. In broad terms, the relation between interest rates and money supply can certainly break down when chaos strikes the markets. But even in a less-than-extreme scenario, that relation may hold and yet the net effect can still be a higher level of prices.

Also keep in mind that printing extra money to honor the government's bonds contributes to depreciation of the domestic currency, and interest rates might not be high enough to attract lenders.

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  • $\begingroup$ Hey. Thanks for your answer! A question: "whereas the purchase power of the bolivar becomes negligible" -- I don't understand why. Shouldn't this apply only to imports? How about the goods and services which are produced in the country? $\endgroup$ – Physicist137 Feb 13 at 21:52
  • $\begingroup$ @Physicist137 A country is very unlikely to produce all the inputs it needs to manufacture its goods and provide its services. Also, investors will withdraw altogether from an economy they foresee will go through rough times, thereby resulting in capital flight and depreciation of the currency. An investor's alternative to ' withdrawal consists of financial hedging, but that involves costs which might prompt an investor to assess the extra opportunity cost of remaining in that economy. $\endgroup$ – Iñaki Viggers Feb 13 at 23:49

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