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Capital Markets and the Instability of Open Economies

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  • Aghion, Philippe
  • Bacchetta, Philippe
  • Banerjee, Abhijit

Abstract

This paper introduces a framework for analyzing the role of financial factors as a source of instability in small open economies. Our basic model is a dynamic open economy model with one tradeable and one non-tradeable good with the non-tradeable being an input to the production of the tradeable. We also assume that firms face credit constraints, with the constraint being tighter at a lower level of financial development. The two basic implications of this model are the following: first, economies at an intermediate level of financial development are more unstable than either very developed or very underdeveloped economies. This is true both in the sense that temporary shocks have large and persistent effects and also in the sense that these economies can exhibit stable limit cycles. Thus, countries that are going through a phase of financial development may become more unstable in the short run. Second, in economies at an intermediate level of financial development, full financial liberalization may actually destabilize the economy. On the other hand, foreign direct investment does not destabilize.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 2083.

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Date of creation: Mar 1999
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Handle: RePEc:cpr:ceprdp:2083

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Keywords: Capital Flows; Credit Constraints; Instability;

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  1. McKinnon, Ronald I & Pill, Huw, 1997. "Credible Economic Liberalizations and Overborrowing," American Economic Review, American Economic Association, vol. 87(2), pages 189-93, May.
  2. Maurice Obstfeld, 1984. "Capital Flows, the Current Account, and the Real Exchange Rate: Consequences of Liberalization and Stabilization," NBER Working Papers 1526, National Bureau of Economic Research, Inc.
  3. R. Glenn Hubbard, 1998. "Capital-Market Imperfections and Investment," Journal of Economic Literature, American Economic Association, vol. 36(1), pages 193-225, March.
  4. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, vol. 51(3), pages 393-414, July.
  5. Bruce, Neil & Purvis, Douglas D., 1985. "The specification and influence of goods and factor markets in open-economy macroeconomic models," Handbook of International Economics, in: R. W. Jones & P. B. Kenen (ed.), Handbook of International Economics, edition 1, volume 2, chapter 16, pages 807-857 Elsevier.
  6. Feldstein, Martin & Horioka, Charles, 1980. "Domestic Saving and International Capital Flows," Economic Journal, Royal Economic Society, vol. 90(358), pages 314-29, June.
  7. Leonardo Bartolini & Allan Drazen, 1996. "When liberal policies reflect external shocks, what do we learn?," Staff Reports 18, Federal Reserve Bank of New York.
  8. repec:fth:harver:1435 is not listed on IDEAS
  9. Martina Copelman, 1996. "The role of credit in post-stabilization consumption booms," International Finance Discussion Papers 569, Board of Governors of the Federal Reserve System (U.S.).
  10. Campbell, John Y. & Mankiw, N. Gregory, 1991. "The response of consumption to income : A cross-country investigation," European Economic Review, Elsevier, vol. 35(4), pages 723-756, May.
  11. John Y. Campbell & N. Gregory Mankiw, 1989. "Consumption, Income, and Interest Rates: Reinterpreting the Time Series Evidence," NBER Working Papers 2924, National Bureau of Economic Research, Inc.
  12. Bacchetta, Philippe & Caminal, Ramon, 2000. "Do capital market imperfections exacerbate output fluctuations?," European Economic Review, Elsevier, vol. 44(3), pages 449-468, March.
  13. Bacchetta, Philippe, 1992. "Liberalization of Capital Movements and of the Domestic Financial System," Economica, London School of Economics and Political Science, vol. 59(236), pages 465-74, November.
  14. Michael Mussa & Giovanni Dell'Ariccia & Barry J. Eichengreen & Enrica Detragiache, 1998. "Capital Account Liberalization," IMF Occasional Papers 172, International Monetary Fund.
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