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.

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Kosuke Aoki, Gianluca Benigno and Nobuhiro Kiyotaki

October 2010     Paper Number CEPDP1014

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This CEP discussion paper is published under the centre's Trade programme.