Capital Markets and the Instability of Open Economies

Philippe Aghion, Philippe Bacchetta and Abhijit Banerjee

No 99.01 update, Working Papers from Swiss National Bank, Study Center Gerzensee

Abstract: This paper introduces a framework for analyzing the role of financial factors as a source of stability in small open economies. Our basic model is a dynamic open economy 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, in economies at a intermediate level of financial development, full capital account liberalization may destabilize the economy. On the other hand, foreign direct investment does not destabilize.

Pages: 46 pages
Date: 2000-11
New Economics Papers: this item is included in nep-dge, nep-fmk and nep-ifn
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Citations: View citations in EconPapers (44)

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Related works:
Working Paper: Capital Markets and the Instability of Open Economies (1999)
Working Paper: Capital Markets and the Instability of Open Economies (1999)
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