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International Capital Flows and Credit Market Imperfections: a Tale of Two Frictions

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  • Alberto Martin
  • Filippo Taddei

Abstract

The financial crisis of 2007-08 has underscored the importance of adverse selection in financial markets. This friction has been mostly neglected by macroeconomic models of financial frictions, however, which have focused almost exclusively on the effects of limited pledgeability. In this paper, well this gap by developing a standard growth model with adverse selection. Our main results are that, by fostering unproductive investment, adverse selection: (i) leads to an increase in the economys equilibrium interest rate, and; (ii) it generates a negative wedge between the marginal return to investment and the equilibrium interest rate. Under financial integration, we show how this translates into excessive capital inflows and endogenous cycles. We also explore how these results change when limited pledgeability is added to the model. We conclude that both frictions complement one another and argue that limited pledgeability exacerbates the effects of adverse selection.

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Bibliographic Info

Paper provided by Barcelona Graduate School of Economics in its series Working Papers with number 518.

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Date of creation: Feb 2012
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Handle: RePEc:bge:wpaper:518

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Keywords: Limited Pledgeability; Adverse Selection; International Capital Flows; Credit Market Imperfections;

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References

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Citations

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Cited by:
  1. Heathcote, Jonathan & Perri, Fabrizio, 2013. "Assessing International Efficiency," CEPR Discussion Papers 9424, C.E.P.R. Discussion Papers.
  2. Broner, Fernando A & Ventura, Jaume, 2010. "Rethinking the Effects of Financial Liberalization," CEPR Discussion Papers 8171, C.E.P.R. Discussion Papers.
  3. Raddatz, Claudio & Schmukler, Sergio L. & Williams, Tomas, 2014. "International asset allocations and capital flows : the benchmark effect," Policy Research Working Paper Series 6866, The World Bank.
  4. Benjamin Moll & Robert M. Townsend & Victor Zhorin, 2013. "Financial Obstacles and Inter-Regional Flow of Funds," NBER Working Papers 19618, National Bureau of Economic Research, Inc.
  5. Arnaud Costinot & Guido Lorenzoni & Iván Werning, 2011. "A Theory of Capital Controls as Dynamic Terms-of-Trade Manipulation," NBER Working Papers 17680, National Bureau of Economic Research, Inc.
  6. Bertsch, Christoph, 2013. "A detrimental feedback loop: deleveraging and adverse selection," Working Paper Series 277, Sveriges Riksbank (Central Bank of Sweden).
  7. Emmanuel Farhi & Ivan Werning, 2012. "Dealing with the Trilemma: Optimal Capital Controls with Fixed Exchange Rates," NBER Working Papers 18199, National Bureau of Economic Research, Inc.

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