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International Capital Flows and Credit Market Imperfections: a Tale of Two Frictions

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  • Alberto Martin
  • Filippo Taddei

Abstract

The financial crisis of 2007-08 has underscored the importance of adverse selection in financial markets. This friction has been mostly neglected by macroeconomic models of financial frictions, however, which have focused almost exclusively on the effects of limited pledgeability. In this paper, we fill this gap by developing a standard growth model with adverse selection. Our main results are that, by fostering unproductive investment, adverse selection: (i) leads to an increase in the economy's equilibrium interest rate, and (ii) it generates a negative wedge between the marginal return to investment and the equilibrium interest rate. Under financial integration, we show how this translates into excessive capital inflows and endogenous cycles. We also explore how these results change when limited pledgeability is added to the model. We conclude that both frictions complement one another and argue that limited pledgeability exacerbates the effects of adverse selection.

Suggested Citation

  • Alberto Martin & Filippo Taddei, 2010. "International Capital Flows and Credit Market Imperfections: a Tale of Two Frictions," Carlo Alberto Notebooks 160, Collegio Carlo Alberto, revised 2011.
  • Handle: RePEc:cca:wpaper:160
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    Cited by:

    1. Taddei, Filippo, 2018. "Financial frictions, international capital flows and welfare," Working Paper Series 2167, European Central Bank.
    2. Bacchetta Philippe & Benhima Kenza, 2010. "The Demand for Liquid Assets, Corporate Saving, and Global Imbalances," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) 10.12, Université de Lausanne, Faculté des HEC, DEEP.
    3. Kikuchi, Tomoo & Vachadze, George, 2015. "Financial liberalization: Poverty trap or chaos," Journal of Mathematical Economics, Elsevier, vol. 59(C), pages 1-9.
    4. Alberto Martin & Jaume Ventura, 2015. "Financial Reforms and Capital Flows: Insights from General Equilibrium," Central Banking, Analysis, and Economic Policies Book Series,in: Ricardo J. Caballero & Klaus Schmidt-Hebbel (ed.), Economic Policies in Emerging-Market Economies Festschrift in Honor of Vittorio Corbo, edition 1, volume 21, chapter 7, pages 109-137 Central Bank of Chile.
    5. Jonathan Heathcote & Fabrizio Perri, 2016. "On the Desirability of Capital Controls," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 64(1), pages 75-102, May.
    6. Arnaud Costinot & Guido Lorenzoni & Iván Werning, 2014. "A Theory of Capital Controls as Dynamic Terms-of-Trade Manipulation," Journal of Political Economy, University of Chicago Press, vol. 122(1), pages 77-128.
    7. Jaume Ventura & Fernando Broner, 2008. "Rethinking the effects of financial liberalization," 2008 Meeting Papers 747, Society for Economic Dynamics.
    8. Damien Cubizol, 2017. "Transition and capital misallocation: the Chinese case," Working Papers halshs-01176919, HAL.
    9. Raddatz, Claudio & Schmukler, Sergio L. & Williams, Tomás, 2017. "International asset allocations and capital flows: The benchmark effect," Journal of International Economics, Elsevier, vol. 108(C), pages 413-430.
    10. Rogelio Mercado Jr., 2016. "Are Capital Inflows Expansionary or Contractionary in the Philippines?," Trinity Economics Papers tep2116, Trinity College Dublin, Department of Economics.
    11. Era Dabla-Norris & Yan Ji & Robert M. Townsend & Filiz D Unsal, 2015. "Identifying Constraints to Financial Inclusion and Their Impact on GDP and Inequality; A Structural Framework for Policy," IMF Working Papers 15/22, International Monetary Fund.
    12. Heathcote, Jonathan & Perri, Fabrizio, 2014. "Assessing International Efficiency," Handbook of International Economics, Elsevier.
    13. Emmanuel Farhi & Ivan Werning, 2012. "Dealing with the Trilemma: Optimal Capital Controls with Fixed Exchange Rates," NBER Working Papers 18199, National Bureau of Economic Research, Inc.
    14. Bertsch, Christoph, 2013. "A detrimental feedback loop: deleveraging and adverse selection," Working Paper Series 277, Sveriges Riksbank (Central Bank of Sweden).
    15. Fernando Broner & Jaume Ventura, 2016. "Rethinking the Effects of Financial Globalization," The Quarterly Journal of Economics, Oxford University Press, vol. 131(3), pages 1497-1542.
    16. Benjamin Moll & Robert M. Townsend & Victor Zhorin, 2013. "Economic Development, Flow of Funds and the Equilibrium Interaction of Financial Frictions," NBER Working Papers 19618, National Bureau of Economic Research, Inc.
    17. Era Dabla-Norris & Yan Ji & Robert M. Townsend & D. Filiz Unsal, 2015. "Distinguishing Constraints on Financial Inclusion and Their Impact on GDP, TFP, and Inequality," NBER Working Papers 20821, National Bureau of Economic Research, Inc.
    18. Maya Eden, 2017. "Misallocation and the Distribution of Global Volatility," American Economic Review, American Economic Association, vol. 107(2), pages 592-622, February.
    19. repec:eee:jetheo:v:176:y:2018:i:c:p:170-192 is not listed on IDEAS
    20. repec:eee:jimfin:v:81:y:2018:i:c:p:88-115 is not listed on IDEAS
    21. Dabla-Norris, Era & Ji, Yan & Townsend, Robert M & Unsal, Derya Filiz, 2017. "Distinguishing Constraints on Financial Inclusion and Their Impact on GDP and Inequality," CEPR Discussion Papers 11742, C.E.P.R. Discussion Papers.

    More about this item

    Keywords

    Limited Pledgeability; Adverse Selection; International Capital Flows; Credit Market Imperfections;

    JEL classification:

    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems

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