DP8087 Adjusting to Capital Account Liberalization

Author(s): Kosuke Aoki, Gianluca Benigno, Nobuhiro Kiyotaki
Publication Date: October 2010
Keyword(s): capital account liberalization, credit frictions, domestic financial markets
JEL(s): F32
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8087

We study theoretically how the adjustment to liberalization of international financial transaction depends upon the degree of domestic financial development. Using a model with domestic and international borrowing constraints, we show that, when the domestic financial system is underdeveloped, capital account liberalization is not necessarily beneficial because TFP stagnates in the long-run or employment decreases in the short-run. Government policy, including allowing foreign direct investment, can mitigate the possible loss of employment, but cannot eliminate it unless the domestic financial system is improved.