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)


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.


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.


Unable to display preview. Download preview PDF.

Unable to display preview. Download preview PDF.


  1. [1.]
    Antinol., G., Huybens, E.: Capital accumulation and real exchange rate behavior in a small open economy with credit market frictions. Economic Theory 12, 461–488 (1998)Google Scholar
  2. [2.]
    Azariadis, C.: Intertemporal macroeconomics. Cambridge: Blackwell Publishers 1993Google Scholar
  3. [3.]
    Bernanke, B. S., Gertler, M.: Agency costs, net worth, and business fluctuations. American Economic Review 79, 14–31 (1989)Google Scholar
  4. [4.]
    Boyd, J. H., Smith, B. D.: How good are standard debt contracts?: Stochastic versus nonstochastic monitoring in a costly state verification environment. Journal of Business 67, 539–561 (1994)CrossRefGoogle Scholar
  5. [5.]
    Boyd, J. H., Smith, B. D.: Capital market imperfections, international credit markets, and nonconvergence. Journal of Economic Theory 73, 335–64 (1997)CrossRefGoogle Scholar
  6. [6.]
    Boyd, J. H., Smith, B. D.: Capital market imperfections in a monetary growth model. Economic Theory 11, 241–273 (1998)CrossRefGoogle Scholar
  7. [7.]
    Caballero, R. J., Krishnamurthy, A.: Emerging market crises: An asset market perspective. NBER Working Paper 6843 (1998)Google Scholar
  8. [8.]
    Calvo, G.: Balance of payment crises in emerging markets. Manuscript, University of Maryland (1998)Google Scholar
  9. [9.]
    Calvo, G.: Why is “the market” so unforgiving?:Lessons from the tequilazo.Manuscript, University of Maryland (1998)Google Scholar
  10. [10.]
    Calvo, G., Mendoza, E.: Mexico’s balance-of-payment crisis: A chronicle of a death foretold. Journal of International Economics 41, 235–264 (1996)Google Scholar
  11. [11.]
    Calvo, G., Mendoza, E.: Capital-markets crises and economic collapse in emerging markets: An informational-frictions approach. American Economic Review 90, 59–64 (2000)CrossRefGoogle Scholar
  12. [12.]
    Chang, R., Velasco, A.: Financial crises in emerging markets: Acanonical model. NBER Working Paper 6606 (1998)Google Scholar
  13. [13.]
    Chang, R., Velasco, A.: Financial fragility and the exchange rate regime. Journal of Economic Theory 92, 1–34 (2000)CrossRefGoogle Scholar
  14. [14.]
    Cole, H., Kehoe, T.: A self-fulfilling model of Mexico’s 1994–1995 debt crisis. Journal of International Economics 41, 309–330 (1996)CrossRefGoogle Scholar
  15. [15.]
    Corsetti, G., Pesenti, P., Roubini, N.: What caused the Asian currency and financial crises? Part I. The macroeconomic overview. NBER Working Paper 6833 (1998)Google Scholar
  16. [16.]
    Del Negro, M., Obiols-Homs, F.: Has monetary policy been so bad that it is better to get rid of it? The case of Mexico. Journal of Money, Credit and Banking 33, 404–433 (2001)Google Scholar
  17. [17.]
    Diamond, P. A.: National debt in a neoclassical growth model. American Economic Review 55, 1026–1050 (1965)Google Scholar
  18. [18.]
    Dornbusch, R., Werner, A.: Mexico: Stabilization, reform, and no growth. Brookings Papers on Economic Activity 1:94, Washington D.C. (1994)Google Scholar
  19. [19.]
    Edwards, S.: Real exchange rates, devaluation, and adjustment. Cambridge: MIT Press 1989Google Scholar
  20. [20.]
    Flood, R. P., Garber, P. M., Kramer, C.: Collapsing exchange rate regimes: Another linear example. Journal of International Economics 41, 223–234 (1996)CrossRefGoogle Scholar
  21. [21.]
    Gale, D., Hellwig, M.: Incentive-compatible debt contracts: The one-period problem. Review of Economic Studies 52, 647–663 (1985)Google Scholar
  22. [22.]
    Galor, O.: A two-sector overlapping-generations model: A global characterization of the dynamical system. Econometrica 60, 1351–1386 (1992)MathSciNetzbMATHGoogle Scholar
  23. [23.]
    Huybens, E., Smith, B. D.: Financial market frictions, monetary policy and capital accumulation in a small open economy. Journal of Economic Theory 81, 353–400 (1998)CrossRefGoogle Scholar
  24. [24.]
    Japelli, T.: Who is credit constrained in the U.S. economy. Quarterly Journal of Economics 105, 219–234 (1990)Google Scholar
  25. [25.]
    Kaminsky, G. L., Reinhart, C. M.: The twin crises: The causes of banking and balance-of-payments problems. American Economic Review 89, 473–500 (1999)CrossRefGoogle Scholar
  26. [26.]
    Kostelich, E. J., Yorke, J. A., You, Z.: Plotting stable manifolds: Error estimates and noninvertible maps. Physica D 93, 210–222 (1996)CrossRefMathSciNetGoogle Scholar
  27. [27.]
    Milesi-Ferretti, G. M., Razin, A.: Current account reversals and currency crises: Empirical regularities. NBER Working Paper 6620 (1998)Google Scholar
  28. [28.]
    Parker, T. S., Chua, L. O.: Practical numerical algorithms for chaotic systems. New York: Springer-Verlag 1989Google Scholar
  29. [29.]
    Radelet, S., Sachs, J.: The onset of the East Asian financial crisis. Manuscript, Harvard Institute of Economic Development (1998)Google Scholar
  30. [30.]
    Sachs, J., Tornell, A., Velasco, A.: The Mexican peso crisis: Sudden death or death foretold? Journal of International Economics 41, 265–283 (1996)CrossRefGoogle Scholar
  31. [31.]
    Summers, L. H.: International financial crises: Causes, prevention, and cures. American Economic Review 90, 1–16 (2000)CrossRefGoogle Scholar
  32. [32.]
    Summers, R., Heston, A.: The Penn World Table (Mark5): An expanded set of international comparisons, 1950–1988. Quarterly Journal of Economics 106, 327–368 (1991)Google Scholar
  33. [33.]
    Stiglitz, J., Weiss, A.: Credit rationing in markets with imperfect information. American Economic Review 71, 393–410 (1981)Google Scholar
  34. [34.]
    Townsend, R.M.: Optimal contracts and competitive markets with costly state verification. Journal of Economic Theory 21, 265–93 (1979)CrossRefzbMATHGoogle Scholar
  35. [35.]
    Williamson, S. D.: Costly monitoring, financial intermediation, and equilibrium credit rationing. Journal of Monetary Economics 18, 159–79 (1986)CrossRefGoogle Scholar
  36. [36.]
    Williamson, S. D.: Costly monitoring, loan contracts, and equilibrium credit rationing. Quarterly Journal of Economics 102, 135–45 (1987)Google Scholar

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

Personalised recommendations