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Domestic financial market frictions, unrestricted international capital flows, and crises in small open economies

  • Gaetano Antinolfi
  • Elisabeth Huybens
Part of the Studies in Economic Theory book series (ECON.THEORY, volume 24)

Summary

We present an example of a small open economy for which small increases in the world interest rate may induce a sharp decline in output and a precipitous depreciation of the nominal and the real exchange rate (RER). Due to a costly state verification problem in domestic credit markets, combined with unrestricted international capital flows, our economy generates two long run equilibria, one with low GDP and a relatively depreciated RER, and one with high GDP and a relatively appreciated RER. The first is always a saddle, while the second may be a sink or a source, depending on the level of the world interest rate. There exists a critical level of the world interest rate above which the high-GDP steady state turns from a sink to a source. A “crisis” is identified in the model with the economy switching from an equilibrium path approaching the high-output steady state to the saddle path approaching the low output steady state. We simulate such a crisis trajectory for our model economy. In Mexico’s recent history, periods of growth associated with an appreciation of the real exchange rate (RER) have alternated with periods of sharp contraction characterized by a depreciation of the RER. Our economy may display such behavior as an equilibrium response to changes in the world interest rate.

Keywords

Interest Rate Real Exchange Rate Small Open Economy Foreign Asset Tradable Sector 
These keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.

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Copyright information

© Springer-Verlag Berlin Heidelberg 2006

Authors and Affiliations

  • Gaetano Antinolfi
    • 1
    • 2
  • Elisabeth Huybens
    • 2
  1. 1.Department of EconomicsWashington UniversitySt. LouisUSA
  2. 2.World Bank AFTM3 J7-137WashingtonUSA

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