Financial Development and the Instability of Open Economies

Philippe Aghion, Philippe Bacchetta and Abhijit Banerjee

No 10246, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: This paper introduces a framework for analyzing the role of financial factors as a source of instability in small open economies. Our basic model is a dynamic open economy model with a tradeable good produced with capital and a country-specific factor. We also assume that firms face credit constraints, with the constraint being tighter at a lower level of financial development. A basic implication of this model is that economies at an intermediate level of financial development are more unstable than either very developed or very underdeveloped economies. This is true both in the sense that temporary shocks have large and persistent effects and also in the sense that these economies can exhibit cycles. Thus, countries that are going through a phase of financial development may become more unstable in the short run. Similarly, full capital account liberalization may destabilize the economy in economies at an intermediate level of financial development: phases of growth with capital inflows are followed by collapse with capital outflows. On the other hand, foreign direct investment does not destabilize.

JEL-codes: E6 P5 (search for similar items in EconPapers)
Date: 2004-01
New Economics Papers: this item is included in nep-dge, nep-ifn, nep-lam, nep-mac and nep-mfd
Note: EFG IFM
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Citations: View citations in EconPapers (209)

Published as Aghion, Philippe, Philippe Bacchetta and Abhijit Banerjee. "Financial Development And The Instability Of Open Economies," Journal of Monetary Economics, 2004, v51(6,Sep), 1077-1106.

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Journal Article: Financial development and the instability of open economies (2004)
Working Paper: Financial Development and the Instability of Open Economies (2004)
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