Capital Flows and the Instability of Small Economies

Abstract

That the financial system is an important source of instability and the propagation mechanism for cyclical fluctuations has come to the fore in the face of the Asian financial crisis. Many economist have argued that, the unregulated operation of the financial markets can lead to excessive fluctuations even in the absense of shocks impinging on the rest of the economy. The study analyses the effects of financial market integration in developing market economies. The basic model is a dynamic open-economy model with two inputs; tradable and non-tradable inputs being used in production and a credit-constraint as to the amount of credit firms' can borrow. We first show that economies at an intermediate level of financial development are more vulnerable to instability than either advanced or least developed economies. In these economies, temporary shocks may have large and long lasting effects. However, there is a limit to which such economies may cycle. This suggests that countries going through financial restructuring may become unstable in the short run. In addition, combining capital market imperfections and unequal access to investment opportunities for individuals can lead to permanent fluctuations in income and investment. Thus governments should aim at reducing inequality of access to credit which may be necessary for macroeconomic stability. Aside the above, other factors such as increases in interest rates, increased uncertainty,and assest market effects on balance sheets may impinge on the stability of small economies. These calls for countercyclical policies targeted at specific problems to be implemented in order to put the economy on a sound footing, for example, during recessions.