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Financial development and the instability of open economies

Aghion, P.; Bachetta, P.; Banerjee, A.; (2004) Financial development and the instability of open economies. (NBER Working Papers 10246). National Bureau of Economic Research: Cambridge, US. Green open access

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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.

Type: Working / discussion paper
Title: Financial development and the instability of open economies
Open access status: An open access version is available from UCL Discovery
Publisher version: http://www.nber.org/papers/w10246
Language: English
Additional information: Please see http://eprints.ucl.ac.uk/17707/ for the version published in the Journal of Monetary Economics
UCL classification: UCL > Provost and Vice Provost Offices > UCL SLASH > Faculty of S&HS > Dept of Economics
URI: https://discovery.ucl.ac.uk/id/eprint/17785
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