Endogenous Financial Intermediation and Real Effects of Capital Account Liberalization

Abstract:     
We consider lending and investment under asymmetric information in a small, developing economy. We allow different forms of financing contracts to arise endogenously in the credit market. Financial intermediaries mitigate a moral hazard problem in investment choice through costly monitoring and liquidation. We then examine the impact of opening the capital account on both welfare and the structure of lending contracts. Depending on the quality and cost of the monitoring technology, liberalizing the capital account may improve or worsen the efficiency of financial intermediaries, leading to an improvement or worsening of the aggregate composition of investment projects. Efficient financial intermediaries are neither necessary nor sufficient for a capital account liberalization to improve welfare.

Number of Pages in PDF File: 41

Keywords: Financial intermediation, capital account, moral hazard, lending contracts

JEL Classification: G2, F3, O1

working papers series