Capital Flows and Financial Intermediation in a Small Open Economy: Business Cycles with Neoclassical Banks (original) (raw)

This paper studies the business cycle implications of exogenous fluctuations in foreign capital inflows driven by world-interest-rate changes in a small open economy with a 'neoclassical' banking system. Banks are the only domestic agents with access to international capital markets. They intermediate capital flows by borrowing abroad and lending to domestic firms and households in a competitive credit market. Firms demand credit to finance their working capital while households use credit to smooth consumption over time. Banks, firms, and households all choose optimally their positions in financial assets. Calibrating different versions of the model to the Argentine economy for 1970-1999, quantitative results indicate that a demand for working capital is not enough to break the neutrality of business cycles to interestrate shocks. Only when the banks' supply of funds is not infinitely elastic, the model produces a volatility of domestic credit consistent with actual statistics. The standard small-open-economy RBC model, even when augmented to include neoclassical banks and working capital, is unable to reproduce the kind of output swings associated with capital outflows that are observed in actual economies.