After the 2008 crisis there were massive capital inflows in emerging economies and since then, policy makers in emerging economies have worried about destabilizing capital flows.

According to Uncovered Interest Parity (UIP) theory, the high yield currency tends to depreciate which can cancel the destabilizing capital flows issue, yet according to empirical studies, the high yield currency tends to appreciate instead. Macro models usually assume UIP to hold. This research introduces short to medium run deviations from UIP in a tractable macroeconomic framework.

It shows that capital flows could destabilize emerging economies. By introducing this effect in a New-Keynesian model, we show that the exchange rate is driven by its position and risk in the FX market and that currencies of indebted countries are likely to depreciate. Monetary policy has the ability to mitigate the destabilizing effect of capital flows and this research shows that in a risky environment, the optimal monetary policy brings more stability. In crisis periods, this policy does not prevent large exchange rate volatility in South Africa.