Capital Flows and Asset Prices

What are the macroeconomic effects of a capital account liberalization? In their work CEP associate Gianluca Benigno, and coauthors Kosuke Aoki and Nobuhiro Kiyotaki analyse the impact of private capital flows.

Results
They tackle this issue by extending to an open economy framework a Kiyotaki and Moore (1997) economy populated by entrepreneurs whose productivity changes stochastically and workers who supply them with their labour. In this economy flows of capital from unproductive lenders to productive borrowers are subject to financial frictions. The entity of these frictions defines the sophistication of a country’s financial system, which characterizes the response to a sudden opening to international borrowing and lending.
A country with an underdeveloped financial system, or strong frictions, will experience large inflows of capital after the liberalization leading to an immediate rise in economic activity and asset prices followed by a long lasting contraction due to the inefficient allocation of capital. Conversely, agents in the more developed country will provide the funds to the former thus initially reducing the availability of capital to domestic productive borrowers. This generates an initial recession, followed by output reaching a higher steady state.

Welfare
The welfare of workers and productive entrepreneurs with the outstanding debt are more influenced by the short-run fluctuations than the long-run performance of the economy. The welfare of the lenders (unproductive entrepreneurs) depends more on the rate of returns in the long run than the short-run effects. These differences in the welfare effects across different groups of people may partly contribute to the controversy on capital account liberalization. If the economy succeeds in improving the domestic financial system simultaneously with the capital account liberalization, then the economy will prosper persistently with the improvement in welfare also being widely distributed.

"Capital Flows and Asset Prices" [Full document in Adobe PDF](Gianluca Benigno, Kosuke Aoki, and Nobuhiro Kiyotaki), Paper No 921, April 2009