Working Paper: NBER ID: w20803
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: international credit flows; pecuniary externalities; capital controls; macroeconomic policy
JEL Codes: F32; F43; G15; O41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| excessive borrowing (F65) | constrained inefficiency (D61) |
| excessive borrowing (F65) | worsening of terms of trade (F14) |
| sudden stops in credit flows (F65) | sharp declines in capital prices (G19) |
| sudden stops in credit flows (F65) | exacerbating vulnerability of undercapitalized countries (F65) |
| capital controls (F38) | improved welfare (I30) |
| capital controls (F38) | mitigating adverse effects of excessive short-term borrowing (F65) |