DP10339 International Credit Flows and Pecuniary Externalities

Author(s): Markus K Brunnermeier, Yuliy Sannikov
Publication Date: January 2015
Keyword(s): hot money, international capital flows, international credit flows, pecuniary externalities, sudden stops, terms of trade hedge
JEL(s): F33, F34, F36, F38, F41, G15
Programme Areas: International Macroeconomics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10339

This paper develops a dynamic two-country neoclassical stochastic growth model with incomplete markets. Short-term credit flows can be excessive and reverse suddenly. The equilibrium outcome is constrained inefficient due to pecuniary externalities. First, an undercapitalized country borrows too much since each firm does not internalize that an increase in production capacity undermines their output price, worsening their terms of trade. From an ex-ante perspective each firm undermines the natural ?terms of trade hedge.? Second, sudden stops and fire sales lead to sharp price drops of illiquid capital. Capital controls or domestic macro-prudential measures that limit short-term borrowing can improve welfare.