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Capital Markets and the Instability of Open Economies

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This paper introduces a framework for analyzing the role of financial factors as a source of stability in small open economies. Our basic model is a dynamic open economy with a tradeable good produced with capital and a country-specific factor. We also assume that firms face credit constraints, with the constraint being tighter at a lower level of financial development. A basic implication of this model is that 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 cycles. Thus, countries that are going through a phase of financial development may become more unstable in the short run. Similarly, in economies at a intermediate level of financial development, full capital account liberalization may 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 update.

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Length: 46 pages
Date of creation: Nov 2000
Date of revision:
Handle: RePEc:szg:worpap:9901update

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  1. Campbell, John Y. & Mankiw, N. Gregory, 1991. "The response of consumption to income : A cross-country investigation," European Economic Review, Elsevier, Elsevier, vol. 35(4), pages 723-756, May.
  2. R. Glenn Hubbard, 1997. "Capital-Market Imperfections and Investment," NBER Working Papers 5996, National Bureau of Economic Research, Inc.
  3. Michael Mussa & Giovanni Dell'Ariccia & Barry J. Eichengreen & Enrica Detragiache, 1998. "Capital Account Liberalization," IMF Occasional Papers, International Monetary Fund 172, International Monetary Fund.
  4. 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), Université de Lausanne, Faculté des HEC, DEEP 9612, Université de Lausanne, Faculté des HEC, DEEP.
  5. Leonardo Bartolini & Allan Drazen, 1996. "When Liberal Policies Reflect External Shocks, What Do We Learn?," NBER Working Papers 5727, National Bureau of Economic Research, Inc.
  6. McKinnon, Ronald I & Pill, Huw, 1997. "Credible Economic Liberalizations and Overborrowing," American Economic Review, American Economic Association, American Economic Association, vol. 87(2), pages 189-93, May.
  7. John Y. Campbell & N. Gregory Mankiw, 1989. "Consumption, Income and Interest Rates: Reinterpreting the Time Series Evidence," NBER Chapters, National Bureau of Economic Research, Inc, in: NBER Macroeconomics Annual 1989, Volume 4, pages 185-246 National Bureau of Economic Research, Inc.
  8. Bruce, Neil & Purvis, Douglas D., 1985. "The specification and influence of goods and factor markets in open-economy macroeconomic models," Handbook of International Economics, Elsevier, in: R. W. Jones & P. B. Kenen (ed.), Handbook of International Economics, edition 1, volume 2, chapter 16, pages 807-857 Elsevier.
  9. repec:fth:harver:1435 is not listed on IDEAS
  10. 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.
  11. Bacchetta, Philippe, 1992. "Liberalization of Capital Movements and of the Domestic Financial System," Economica, London School of Economics and Political Science, London School of Economics and Political Science, vol. 59(236), pages 465-74, November.
  12. Martin Feldstein & Charles Horioka, 1979. "Domestic Savings and International Capital Flows," NBER Working Papers 0310, National Bureau of Economic Research, Inc.
  13. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 51(3), pages 393-414, July.
  14. Martina Copelman, 1996. "The role of credit in post-stabilization consumption booms," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 569, Board of Governors of the Federal Reserve System (U.S.).
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