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Financial Market Imperfections, Real Exchange Rates, and Capital Flows

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  • Caroline Betts

    (University of Southern California)

  • Elisabeth Huybens

    (Centro de Investigacion Economica (CIE), Instituto Tecnologico Autonomo de Mexico (ITAM))

Abstract

We explore the role of domestic financial market frictions in explaining sharp movements in real and nominal exchange rates, capital flows, and output for a small open economy. Financial intermediaries arise endogenously to insulate depositors from the consequences of liquidity shocks and stochastic investment project returns, and to provide intermediation for efficient capital accumulation in the presence of a costly state verification problem. An increase in the world interest rate may provoke an increase in the fraction of credit-rationed entrepreneurs, a decrease in the steady state capital stock, and - when the elasticity of substitution between labor and capital is low - a depreciation of the real exchange rate and an outflow of capital. Hence we can account qualitatively for the recent experience of several emerging market economies in a model where all prices, including exchange rates, are perfectly flexible.

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File URL: http://ftp.itam.mx/pub/academico/inves/huybens/9902.pdf
File Function: First version, 1999
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Bibliographic Info

Paper provided by Centro de Investigacion Economica, ITAM in its series Working Papers with number 9902.

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Length: 50 pages
Date of creation: Aug 1999
Date of revision:
Handle: RePEc:cie:wpaper:9902

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  1. Stacey L. Schreft & Bruce D. Smith, 1994. "Money, banking, and capital formation," Working Paper 94-05, Federal Reserve Bank of Richmond.
  2. Bhattacharya, Joydeep, et al, 1997. "Monetary, Fiscal, and Reserve Requirement Policy in a Simple Monetary Growth Model," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 38(2), pages 321-50, May.
  3. Champ, B. & Snith, B.D. & Williamson, D.S., 1991. "Currency Elasticity and Banking Panics: Theory and Evidence," RCER Working Papers 292, University of Rochester - Center for Economic Research (RCER).
  4. Boyd, John H. & Smith, Bruce D., 1997. "Capital Market Imperfections, International Credit Markets, and Nonconvergence," Journal of Economic Theory, Elsevier, vol. 73(2), pages 335-364, April.
  5. Joydeep Bhattacharya & Mark G. Guzman & Elisabeth Huybens & Bruce D. Smith, 1995. "Monetary, Fiscal, and Bank Regulatory Policy in a Simple Monetary Growth Model," Working Papers 9501, Centro de Investigacion Economica, ITAM.
  6. Betts, Caroline M & Smith, Bruce D, 1997. "Money, Banking, and the Determination of Real and Nominal Exchange Rates," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 38(3), pages 703-34, August.
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