International Credit and Welfare: A Paradoxical Theorem and its Policy Implications

Abstract:     
This paper considers a developing nation that faces a foreign exchange shortage and hence its demand for foreign goods is limited both by its income and its foreign exchange balance. Availability of international credit relaxes the second constraint. We develop a simple model of strategic interaction between lending institutions and firms, and show that the availability of international credit at concessionary rates can leave the borrowing nation worse off than if it had to borrow money at higher market rates. This paradox of benevolence is then used to motivate a discussion of policies pertaining to international lending and the Southern government's method of rationing out foreign exchange to the importers.

Keywords: Bank-firm interaction, foreign aid, international credit, welfare comparison

JEL Classifications: L10, F30, O10

Working Paper Series