Working Paper: CEPR ID: DP10339
Authors: Markus K. Brunnermeier; Yuliy Sannikov
Abstract: This paper develops a dynamic two-country neoclassical stochastic growth model with incomplete markets. Short-term credit flows can be excessive and reverse suddenly. The equilibrium outcome is constrained inefficient due to pecuniary externalities. First, an undercapitalized country borrows too much since each firm does not internalize that an increase in production capacity undermines their output price, worsening their terms of trade. From an ex-ante perspective each firm undermines the natural ?terms of trade hedge.? Second, sudden stops and fire sales lead to sharp price drops of illiquid capital. Capital controls or domestic macro-prudential measures that limit short-term borrowing can improve welfare.
Keywords: hot money; international capital flows; international credit flows; pecuniary externalities; sudden stops; terms of trade hedge
JEL Codes: F33; F34; F36; F38; F41; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| excessive borrowing (F65) | worsening economic conditions (E66) |
| sudden stops in credit flow (F65) | fire sales of illiquid capital (G33) |
| fire sales of illiquid capital (G33) | sharp declines in capital prices (G19) |
| capital controls (F38) | enhanced welfare (I38) |
| sudden stops in credit flow (F65) | economic instability (E32) |
| excessive borrowing (F65) | sudden stops in credit flow (F65) |