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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, we fill 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 economy's 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 Collegio Carlo Alberto in its series Carlo Alberto Notebooks with number 160.

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Length: 34 pages
Date of creation: 2010
Date of revision: 2011
Handle: RePEc:cca:wpaper:160

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

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References

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  14. repec:bla:restud:v:75:y:2008:i:3:p:809-833 is not listed on IDEAS
  15. Fernando A Broner & Jaume Ventura, 2006. "Globalization and Risk Sharing," Working Papers 307, Barcelona Graduate School of Economics.
  16. Filippo Taddei, 2010. "Liquidity and Economic Fluctuations," Carlo Alberto Notebooks 138, Collegio Carlo Alberto.
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Cited by:
  1. Fernando A. Broner & Jaume Ventura, 2010. "Rethinking the Effects of Financial Liberalization," NBER Working Papers 16640, National Bureau of Economic Research, Inc.
  2. 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.
  3. Jonathan Heathcote & Fabrizio Perri, 2013. "Assessing International Efficiency," Working Papers 476, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.

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