Capital Flows and Asset Prices

After liberalizing international transaction of financial assets, many countries experience large swings in asset prices, capital flows, and aggregate production. This chapter studies how the adjustment to capital account liberalization depends upon the degree of development of a domestic financial system, and why the economy with an underdeveloped financial system may be vulnerable to shocks to the domestic and foreign finance. We construct a model of a small open economy in which it is difficult to enforce debtors to repay their debts unless the debts are se-cured by collateral, and assets usable as collateral for international borrowing are more restricted than domestic borrowing.