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International Capital Flows, Financial Frictions and Welfare

Filippo Taddei

No 1160, 2013 Meeting Papers from Society for Economic Dynamics

Abstract: The financial crisis of 2007-08 has underscored the importance of adverse selection in financial markets. This friction has been mostly neglected by macroeconomic models of financial imperfections, however, which have focused almost exclusively on limited pledgeability. We fill this gap by developing a standard growth model with adverse selection and extend it to the more general case in which adverse selection and limited pledgeability coexist. We conclude that both frictions complement one another and show that limited pledgeability may exacerbates the effects of adverse selection.We apply this result to show that (i) the welfare effects of international capital flows depend on the nature of the prevailing financial frictions at the domestic and international level and; (ii) the appropriate policy response depend on the specific nature of financial frictions.

Date: 2013
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