Financial Development and the Instability of Open Economies

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.

Measuring and explaining the volatility of capital flows to emerging countries

“…A higher value for both variables should indicate more developed and liquid equity markets. Aghion et al (2004) point to a non-linear relationship between the development of financial systems and capital flow volatility. According to them, only the economies at an intermediate stage of financial development display higher volatility.…”

History’s a curse: leapfrogging, growth breaks and growth reversals under international borrowing without commitment

“…Similar to the large literature showing that foreign borrowing might be detrimental to macroeconomic stability (see, among many others, Paasche 2001; Aghion et al 2004;Mendoza 2010;Devereux and Yetman 2010), we focus on capital equipment as pledgeable collateral. However, our main departure from the existing body of research is that we relax the assumption of commitment to investment.…”

“…We examine how financial integration disrupts macroeconomic stability, as in Aghion et al (2004) who, however, do not focus on growth and emphasize a different mechanism by which variations in the price of a nontradable input affects net worth and borrowing. Similar to Stokey (2010) and McDermott (2010), our model admits a balanced growth path such that the growth rate is negative, which turns out to be unstable under our assumptions.…”

The efficacy of the Egyptian bank reform plan in mitigating the impact of the global financial crisis

“…On the one hand, some empirical studies using Data Envelopment Analysis show how financial liberalization and uncontrollable expansion of credit by the banking sector may have serious destabilizing effects (Schneider and Tornell 2004;Aghion . Also, studies that utilize panel data estimation methods such as Anderson and Hasio (1981), Arellano and Bond (1991), and Greuning et al (2000) demonstrate how the expansion in bank credit boosts macroeconomic growth.…”