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PROCYCLICAL INTERNATIONAL CAPITAL FLOWS, DEBT OVERHANG AND VOLATILITY

Patrick Pintus

Working Papers from HAL

Abstract: In this paper, is show how procyclical capital flows originate boom-bust and sunspot episodes in a neoclassical growth model of a small, open economy. All markets are perfect, with the exception of the fact that some upper, endogenous limit is imposed on how much the economy can borrow from foreign creditors, due to potential debtor default. It is shown that the steady state is locally indeterminate when the credit multiplier is larger than some threshold level, whereas saddle-point stability prevails when the credit multiplier is low enough. As a consequence, high levels of the credit multiplier lead to both booms followed by busts and sunspot-driven volatility near the steady state, while, in contrast, low levels ensure monotonic convergence. Compared with saddle-path equilibria, boom-bust and sunspot equilibria are associated with both lower welfare and debt overhang, that is, a crowding-out effect of credit : when the economy is highly leveraged, it uses savings to cut down foreign debt, at the expense of both human and physical investment. Numerical examples show that volatility arises at rather low values of financial development and for debt-to-GDP ratios that fall within the range of available estimates. Finally, the effects of shocks to the world interest rate on output and consumption are amplified and persistent in the debt overhang regime.

Keywords: international financial markets; endogenous borrowing constraints; small open economy; debt overhang; business cycles; indeterminacy; sunspot equilibria (search for similar items in EconPapers)
Date: 2007-12-01
Note: View the original document on HAL open archive server: https://shs.hal.science/halshs-00353596
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Citations: View citations in EconPapers (4)

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