Working Paper: NBER ID: w10246
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 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, full capital account liberalization may destabilize the economy in economies at an intermediate level of financial development: phases of growth with capital inflows are followed by collapse with capital outflows. On the other hand, foreign direct investment does not destabilize.
Keywords: financial development; economic instability; open economies; capital account liberalization; foreign direct investment
JEL Codes: E6; P5
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Financial Development (Intermediate) (G00) | Economic Instability (E32) |
| Temporary Shocks (E32) | Economic Instability (Intermediate) (E32) |
| Financial Development (Intermediate) (G00) | Limit Cycles (E32) |
| Full Capital Account Liberalization (F32) | Economic Instability (Intermediate) (E32) |
| Increased Investment (E22) | Higher Output (E23) |
| Higher Output (E23) | Input Prices (L11) |
| Input Prices (L11) | Profits and Creditworthiness (G32) |
| Profits and Creditworthiness (G32) | Investment (G31) |
| Investment (G31) | Output (Y10) |