Financial Development and the Instability of Open Economies

48 Pages Posted: 31 Jan 2004 Last revised: 2 Jul 2010

See all articles by Philippe Aghion

Philippe Aghion

College de France and London School of Economics and Political Science, Fellow; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Abhijit V. Banerjee

Massachusetts Institute of Technology (MIT) - Department of Economics

Philippe Bacchetta

University of Lausanne; Centre for Economic Policy Research (CEPR); Swiss Finance Institute

Date Written: January 2004

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.

Suggested Citation

Aghion, Philippe and Banerjee, Abhijit V. and Bacchetta, Philippe, Financial Development and the Instability of Open Economies (January 2004). NBER Working Paper No. w10246. Available at SSRN: https://ssrn.com/abstract=492359

Philippe Aghion (Contact Author)

College de France and London School of Economics and Political Science, Fellow ( email )

London
United Kingdom

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Abhijit V. Banerjee

Massachusetts Institute of Technology (MIT) - Department of Economics ( email )

50 Memorial Drive
Room E52-252D
Cambridge, MA 02142
United States
617-253-8855 (Phone)
617-253-6915 (Fax)

Philippe Bacchetta

University of Lausanne ( email )

Faculty of Business and Economics
Internef 523
1015 Lausanne
Switzerland

HOME PAGE: http://www.hec.unil.ch/pbacchetta/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

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