Working Paper: CEPR ID: DP2083
Authors: Philippe Aghion; Philippe Bacchetta; Abhijit Banerjee
Abstract: This paper introduces a framework for analyzing the role of financial factors as a source of instability in small open economies. Our basic model is a dynamic open economy model with one tradeable and one non-tradeable good with the non-tradeable being an input to the production of the tradeable. We also assume that firms face credit constraints, with the constraint being tighter at a lower level of financial development. The two basic implications of this model are the following: first, 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 stable limit cycles. Thus, countries that are going through a phase of financial development may become more unstable in the short run. Second, in economies at an intermediate level of financial development, full financial liberalization may actually destabilize the economy. On the other hand, foreign direct investment does not destabilize.
Keywords: instability; credit constraints; capital flows
JEL Codes: E32; E44; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Intermediate level of financial development (G00) | more unstable economies (F65) |
| Full financial liberalization (F30) | destabilization of intermediate economies (F69) |
| Foreign direct investment (F21) | destabilization of intermediate economies (F69) |
| Credit constraints + capital mobility (F32) | instability in intermediate financial markets (D53) |
| Temporary shocks (E32) | large and persistent effects in intermediate economies (F69) |
| Shocks to cash flow (G19) | pronounced impact on investment and output dynamics (E22) |