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Capital Markets and the Instability of Open Economies

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Author Info
Philippe Aghion (University College London and Harvard University)
Philippe Bacchetta () (Studienzentrum Gerzensee and Université de Lausanne)
Abhijit Banerjee (Massachusetts Institute of Technology)

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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 constaint 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 persistenst 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 my actually destabilize the economy. On the other hand, foreign direct investment does not destabilize.

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Paper provided by Swiss National Bank, Study Center Gerzensee in its series Working Papers with number 99.01.

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Length: 46 pages
Date of creation: Jan 1999
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Handle: RePEc:szg:worpap:9901

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  1. Bartolini, Leonardo & Drazen, Allan, 1997. "When liberal policies reflect external shocks, what do we learn?," Journal of International Economics, Elsevier, vol. 42(3-4), pages 249-273, May. [Downloadable!] (restricted)
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  2. 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. [Downloadable!] (restricted)
  3. 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. [Downloadable!] (restricted)
  4. Martin Feldstein & Charles Horioka, 1980. "Domestic Savings and International Capital Flows," NBER Working Papers 0310, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  5. Gordon de Brouwer, 1996. "Consumption and Liquidity Constraints in Australia and East Asia: Does Financial Integration Matter?," RBA Research Discussion Papers rdp9602, Reserve Bank of Australia. [Downloadable!]
  6. Giovanni Dell'Ariccia & Enrica Detragiache & Michael Mussa & Barry J. Eichengreen, 1998. "Capital Account Liberalization: Theoretical and Practical Aspects," IMF Occasional Papers 172, International Monetary Fund.
  7. Philippe BACCHETTA & CRamon CAMINAL, 1996. "Do Capital Market Imperfections Exacerbate Output Fluctuations ?," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) 9612, Université de Lausanne, Faculté des HEC, DEEP.
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  8. R. Glenn Hubbard, 1998. "Capital-Market Imperfections and Investment," Journal of Economic Literature, American Economic Association, vol. 36(1), pages 193-225, March. [Downloadable!] (restricted)
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  9. Kiyotaki, Nobuhiro & Moore, John, 1997. "Credit Cycles," Journal of Political Economy, University of Chicago Press, vol. 105(2), pages 211-48, April.
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  10. repec:fth:harver:1435 is not listed on IDEAS
  11. 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.). [Downloadable!]
  12. 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. [Downloadable!] (restricted)
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