The Development of Financial Intermediation and Real Effects of Capital Account Liberalization
48 Pages Posted: 13 Oct 2001
Date Written: July 2001
We consider lending and investment under asymmetric information in an emerging economy. We allow for different forms of financial contracts to arise endogenously in the credit market. We examine the impact of opening the capital account on both aggregate output level and the structure of lending arrangements. Financial intermediaries mitigate the moral hazard problem in investment choice through costly monitoring all projects and liquidating risky, negative NPV projects. Depending on the quality and cost of the monitoring technology, opening the capital account may strengthen or weaken the role of financial intermediaries, leading to an improvement or worsening of the aggregate composition of investment projects. Our results suggest situations where limiting the capital inflow or outflow may be necessary to avoid an aggregate risk shift and the collapse of the financial intermediation sector.
JEL Classification: G2, F3, O
Suggested Citation: Suggested Citation