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Financial Market Frictions, Monetary Policy, and Capital Accumulation in a Small Open Economy

  • Huybens, Elisabeth
  • Smith, Bruce D.

We consider a small open economy where domestic residents combine their own income with credit obtained either at home or abroad in order to finance capital investments. These investments are subject to a costly state verification (CSV) problem. In addition, lenders to domestic residents confront a binding reserve requirement. Under one technical condition, the presence of these credit market frictions leads to the existence of two steady state equilibria: one with a relatively high and one with a relatively low capital stock. The low-capital-stock steady state is a saddle, while the high-capital-stock steady state may be either a sink or a source, depending on the rate of domestic money creation, the world interest rate and the level of domestic reserve requirements. An increase in the rate of money creation, the world interest rate or the level of reserve requirements acts to raise (lower) the level of real activity in the high (low)-capital-stock steady state. At the same time, sufficiently large increases in the rate of money growth or the world interest rate can transform the high-capital-stock steady state from a sink to a source. Thus, while small increases in the rate of interest or the money growth rate may be conducive to higher long-run levels of real activity, excessive increases can induce a kind of ''crisis''. This finding accords well with an array of empirical evidence. Finally, the model delivers a set of prescriptions for what a small open economy can do to protect itself against a ''crisis'' induced by rising world interest rates.

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Article provided by Elsevier in its journal Journal of Economic Theory.

Volume (Year): 81 (1998)
Issue (Month): 2 (August)
Pages: 353-400

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Handle: RePEc:eee:jetheo:v:81:y:1998:i:2:p:353-400
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/622869

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  1. Boyd, John H & Smith, Bruce D, 1994. "How Good Are Standard Debt Contracts? Stochastic versus Nonstochastic Monitoring in a Costly State Verification Environment," The Journal of Business, University of Chicago Press, vol. 67(4), pages 539-61, October.
  2. Robert Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report 45, Federal Reserve Bank of Minneapolis.
  3. 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.
  4. Stephen D. Williamson, 1984. "Costly Monitoring, Financial Intermediation, and Equilibrium Credit Rationing," Working Papers 583, Queen's University, Department of Economics.
  5. Gale, Douglas & Hellwig, Martin, 1985. "Incentive-Compatible Debt Contracts: The One-Period Problem," Review of Economic Studies, Wiley Blackwell, vol. 52(4), pages 647-63, October.
  6. Williamson, Stephen D, 1987. "Costly Monitoring, Loan Contracts, and Equilibrium Credit Rationing," The Quarterly Journal of Economics, MIT Press, vol. 102(1), pages 135-45, February.
  7. Lucas, Robert E, Jr, 1990. "Why Doesn't Capital Flow from Rich to Poor Countries?," American Economic Review, American Economic Association, vol. 80(2), pages 92-96, May.
  8. James Bullard & John Keating, 1994. "Superneutrality in postwar economies," Working Papers 1994-011, Federal Reserve Bank of St. Louis.
  9. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, vol. 79(1), pages 14-31, March.
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