Domestic financial market frictions, unrestricted international capital flows, and crises in small open economies

Gaetano Antinolfi () and Elisabeth Huybens
Additional contact information
Gaetano Antinolfi: Washington University
Elisabeth Huybens: World Bank AFTM3 J7-137

A chapter in Recent Developments on Money and Finance, 2006, pp 61-92 from Springer

Abstract: Summary We present an example of a small open economy for which small increases in the world interest rate may induce a sharp decline in output and a precipitous depreciation of the nominal and the real exchange rate (RER). Due to a costly state verification problem in domestic credit markets, combined with unrestricted international capital flows, our economy generates two long run equilibria, one with low GDP and a relatively depreciated RER, and one with high GDP and a relatively appreciated RER. The first is always a saddle, while the second may be a sink or a source, depending on the level of the world interest rate. There exists a critical level of the world interest rate above which the high-GDP steady state turns from a sink to a source. A “crisis” is identified in the model with the economy switching from an equilibrium path approaching the high-output steady state to the saddle path approaching the low output steady state. We simulate such a crisis trajectory for our model economy. In Mexico’s recent history, periods of growth associated with an appreciation of the real exchange rate (RER) have alternated with periods of sharp contraction characterized by a depreciation of the RER. Our economy may display such behavior as an equilibrium response to changes in the world interest rate.

Keywords: Interest Rate; Real Exchange Rate; Small Open Economy; Foreign Asset; Tradable Sector (search for similar items in EconPapers)
Date: 2006
References: Add references at CitEc
Citations:

There are no downloads for this item, see the EconPapers FAQ for hints about obtaining it.

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:spr:steccp:978-3-540-29500-6_4

Ordering information: This item can be ordered from
http://www.springer.com/9783540295006

DOI: 10.1007/3-540-29500-3_4

Access Statistics for this chapter

More chapters in Studies in Economic Theory from Springer
Bibliographic data for series maintained by Sonal Shukla () and Springer Nature Abstracting and Indexing ().