Financial Market Frictions, Monetary Policy and Capital Accumulation in a Small Open Economy
AbstractWe consider a small open economy where domestic residents combine their own income with credit obtained either at home or abroad in order to finance capital investments. These investments are subject to a costly state verification (CSV) problem. In addition, lenders to domestic residents confront a binding reserve requirement. Under one technical condition, the presence of these credit market frictions leads to the existence of two steady state equilibria: one with a relatively high and one with a relatively low capital stock. The low-capital-stock steady state is a saddle, while the high-capital-stock steady state may be either a sink or a source, depending on the rate of domestic money creation, the world interest rate and the level of domestic reserve requirements. An increase in the rate of money creation, the world interest rate or the level of reserve requirements acts to raise (lower) the level of real activity in the high (low)-capital-stock steady state. At the same time, sufficiently large increases in the rate of money growth or the world interest rate can transform the high-capital-stock steady state from a sink to a source. Thus, while small increases in the rate of interest or the money growth rate may be conducive to higher long-run levels of real activity, excessive increases can induce a kind of ''crisis''. This finding accords well with an array of empirical evidence. Finally, the model delivers a set of prescriptions for what a small open economy can do to protect itself against a ''crisis'' induced by rising world interest rates.
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Bibliographic InfoPaper provided by Centro de Investigacion Economica, ITAM in its series Working Papers with number 9608.
Length: 46 pages
Date of creation: Aug 1996
Date of revision:
Other versions of this item:
- Huybens, Elisabeth & Smith, Bruce D., 1998. "Financial Market Frictions, Monetary Policy, and Capital Accumulation in a Small Open Economy," Journal of Economic Theory, Elsevier, vol. 81(2), pages 353-400, August.
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