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Credit Constraints and Macroeconomic Instability in a Small Open Economy

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  • Luis Felipe Céspedes
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    Abstract

    This paper presents a dynamic model for a small open economy with imperfect financial market. It provides a framework to analyze the role of credit constraints and debt denomination in the generation and amplification of macroeconomic instability in an open economy context. As in Bernanke and Gertler (1989), the imperfection in the financial market results from the existence of a costly state of verification (CSV) problem. Entrepreneurs whose net worth is not enough to finance their desired physical investment have to pay a premium above the risk-free interest rate to obtain external funds. Other key ingredients of the model are that a foreign good is used as an input in the production of the capital good, and that the debt is denominated in terms of the foreign good. Real exchange rate depreciations generate an increase in the cost of producing capital and a reduction in the net worth of entrepreneurs due to the debt denomination. Therefore, recessionary effects can be deepened

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    Bibliographic Info

    Paper provided by Econometric Society in its series Econometric Society 2004 Latin American Meetings with number 264.

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    Date of creation: 11 Aug 2004
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    Handle: RePEc:ecm:latm04:264

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    Keywords: Exchange rates; credit constraints; open economy.;

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    17. Diaz-Alejandro, Carlos, 1985. "Good-bye financial repression, hello financial crash," Journal of Development Economics, Elsevier, vol. 19(1-2), pages 1-24.
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