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International Capital Mobility and Aggregate Volatility: the Case of Credit-Rationed Open Economies

This paper studies how international capital mobility affects aggregate volatility by considering the case of imperfect financial markets such that only physical capital serves as collateral for international borrowing, whereas human capital cannot. We find that credit-rationed, small open economies may be destabilized by expectation-driven fluctuations, even in the presence of small externalities, provided that the share of human capital is low enough. It follows that economies that highly borrow on international credit markets are more susceptible, through a financial accelerator effect, to expectation-driven fluctuations. Moreover, opening the capital account may push a saddle-point stable economy on a volatile path. On the contrary, tighter constraints on external borrowing may protect the economy against expectation-driven volatility. In contrast with existing results relying on the assumption of perfect financial markets, both the elasticity of labor supply and the elasticity of intertemporal substitution in consumption, though less traditionally, condition the set of parameter values associated with expectation-driven fluctuations. Finally, we extend the basic model and show, first, that tax progressivity (resp. regressivity) may protect (resp. expose) the economy against (resp. to) expectation-driven volatility and, second, that our main results do not specifically depend on the presence of externalities.

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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2004 with number 193.

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Date of creation: 11 Aug 2004
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Handle: RePEc:sce:scecf4:193
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