What effect can capital flight have on an economy?

Capital flight refers to the rapid exit of financial assets from a country, often in response to factors like political instability, economic uncertainty, or unfavorable government policies. When investors pull their funds out of a nation, it typically leads to a significant outflow of capital, which can create downward pressure on the country's currency.

A reduction in currency value occurs because the sudden sale of domestic assets to convert them into foreign currency increases the supply of the domestic currency in the foreign exchange market while simultaneously decreasing demand for it. This depreciation can result in various negative effects for the economy, including higher import costs, increased inflation, and challenges for businesses that rely on foreign input or loans.

In contrast, other options—such as an increase in foreign investment, stabilization of financial markets, or a boost to economic growth—are unlikely outcomes of capital flight. Increased foreign investment generally requires confidence in the local economy, which is diminished during capital flight, while stabilization of financial markets conflicts with the turbulence created by sudden capital outflows. Additionally, the negative effects on the currency and investor confidence typically do not support the idea of economic growth. Thus, the most direct and immediate impact of capital flight is the reduction in the value of the currency.