A Welfare Analysis of Hot Money

Abstract:     
There is ample evidence that cross-country contagion of financial crisis is caused by short-term capital flows (hot money), which is sometimes used in order to justify a policy of restricting the integration of the world's liquidity markets -- fragmentation. In a model with under-provision of liquidity, contagion and excessively-high probability of financial crisis, we show that fragmentation has an ambiguous effect on welfare. Indeed, we show that when a country encloses liquidity into its own market it deprives its neighbour from liquidity, increasing the neighbor's probability of financial crisis. Fragmentation may also imply that a country may "sit" on idle liquidity while its neighbor suffers from a financial crisis. Hence, there are conceivable circumstances where the welfare cost of fragmentation dominate the benefits, giving rise to "optimal contagion" in the second-best sense. Policy coordination plays an important role in our analysis.

Number of Pages in PDF File: 46

Keywords: Contagion, capital flows, market fragmentation

JEL Classification: F30, F42, G18

working papers series