Capital Flows and Asset Prices

Abstract

After liberalizing international transaction of …nancial assets, many countries experience large swings in asset prices, capital ‡ows, and aggregate production. This paper studies how the adjustment to capital account liberalization depends upon the degree of development of domestic …nancial system, and why the economy with underdeveloped …nancial system may be vulnerable to shocks to the domestic and foreign …nance. We construct a model of small open economy in which it is di ¢ cult to enforce debtors to repay their debts unless the debts are secured by collateral, and assets usable as collateral for international borrowing are more restricted than domestic borrowing.

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