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I the less likely it is that capital inflows will have an inflationary effect. Under a managed float or a fixed exchange rate system, whether or not capital inflows create inflationary pressures will depend on whether the inflows reflect an upward shift in the money demand function—that is, an increase in money demanded for each interest rate level—or are due to other factors, such as a drop in international interest rates or an increase in the domestic productivity of capital. If capital inflows are due primarily to a sustained increase in domestic money demand, they will not be inflationary. But if they increase for other reasons, the accumulation of foreign exchange reserves will lead, in the absence of sterilization, to expansion of the monetary base, heightened inflationary pressures, and deterioration of the external position.

Financial indicators that may help policymakers differentiate between inflows caused by a shift in the money demand function and those driven by exogenous factors include asset prices, monetary and credit aggregates, balance of payments data, and key international variables, such as interest rates (Table 1). Data on asset prices, both domestic and international, are likely to be more timely than data on monetary and credit aggregates and the external accounts and, therefore, more useful as indicators in this context. The usefulness of different domestic financial indicators depends on an economy’s institutional structure and on the sophistication of a country’s data-gathering and statistical reporting systems. In countries with established financial