Summary.
We present an example of a small open economy where small increases in the world interest rate may induce a sharp decline in output and a precipitous depreciation of the exchange rate. Due to a costly state verification problem in domestic credit markets, combined with unrestricted international capital flows, our economy generates two long-run equilibria, one with low GDP and a relatively depreciated real exchange rate (RER), and one with high GDP and a relatively appreciated RER. The first is always a saddle, while the second may be a sink or a source, depending on the level of the world interest rate. A “crisis” is identified with the economy switching from an equilibrium path approaching the high-output steady state to the saddlepath approaching the low-output steady state. In Mexico’s recent history, periods of growth associated with appreciation of the RER have alternated with periods of sharp contraction and depreciation of the RER. Our economy displays such behavior in response to changes in the world interest rate.
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Received: 9 April 2002, Revised: 20 March 2003
JEL Classification Numbers:
E5, F4.
G. Antinolfi, E. Huybens: We thank Steve Fazzari, Tim Kehoe, Todd Keister, Manuel Santos, Karl Shell and especially Bruce Smith for very helpful discussions. Jaime Calleja Alderete, Eduardo Camero Godínez, and Juan Vargas Hernández provided excellent research assistance. All remaining errors are ours. Huybens was an assistant professor in the Centro de Investigación Económica, ITAM, at the time this article was written, and part of this work was completed while Antinolfi was a visiting scholar at the Federal Reserve Bank of St. Louis. The views expressed herein are those of the authors, and do not reflect those of the World Bank or the Federal Reserve Bank of St. Louis.
Correspondence to: G. Antinolfi
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Antinolfi, G., Huybens, E. Domestic financial market frictions, unrestricted international capital flows, and crises in small open economies. Economic Theory 24, 811–837 (2004). https://doi.org/10.1007/s00199-002-0324-5
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DOI: https://doi.org/10.1007/s00199-002-0324-5