Liquidity-Driven Growth Cycles in Small Open Economies

Jess Benhabib, Feng Dong, Pengfei Wang and Zhenyang Xu

No 35035, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: While standard sudden-stop models explain well the sharpness of financial crises, it remains challenging to account for the persistent growth stagnation that typically follows credit-driven capital account liberalizations in emerging markets. This paper presents a small open economy model with endogenous growth and borrowing constraints to ex- plain this phenomenon. The model highlights a valuation optimistic growth expectations, fueled by foreign credit with perfectly elastic supply, raise asset prices and relax liquidity constraints, inducing investment that validates the initial optimism. This positive feed- back loop generates multiple balanced growth paths and self-fulfilling cycles. However, in closed economies or with only FDI inflows, funding supply for investment is limited by consumption smoothing, dampening this feedback and leading to a unique growth path. Belief-driven regime switches can replicate crisis dynamics, including sharp drops in asset prices and growth. The framework also exhibits periodic orbits, producing endogenous deterministic fluctuations under perfect foresight. Countercyclical macroprudential measures can disrupt the detrimental feedback loop, while policies prioritizing FDI over credit prevent bad equilibria altogether, guiding the economy toward a stable, high-growth trajectory.

JEL-codes: E32 E44 F41 G01 G15 (search for similar items in EconPapers)
Date: 2026-04
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