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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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Citations

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Cited by:
  1. Arnaud Costinot & Guido Lorenzoni & Iv�n Werning, 2014. "A Theory of Capital Controls as Dynamic Terms-of-Trade Manipulation," Journal of Political Economy, University of Chicago Press, vol. 122(1), pages 77 - 128.
  2. Fernando A. Broner & Jaume Ventura, 2010. "Rethinking the Effects of Financial Liberalization," NBER Working Papers 16640, National Bureau of Economic Research, Inc.
  3. Bertsch, Christoph, 2013. "A detrimental feedback loop: deleveraging and adverse selection," Working Paper Series 277, Sveriges Riksbank (Central Bank of Sweden).
  4. Heathcote, Jonathan & Perri, Fabrizio, 2013. "Assessing International Efficiency," CEPR Discussion Papers 9424, C.E.P.R. Discussion Papers.
  5. 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.
  6. 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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