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International Capital Flows and Credit Market Imperfections: a Tale of Two Frictions

Author

Listed:
  • Alberto Martin
  • Filippo Taddei
Abstract
The financial crisis of 2007-08 has underscored the importance of adverse selection in financial markets. This friction has been mostly neglected by macroeconomic models of financial frictions, however, which have focused almost exclusively on the effects of limited pledgeability. In this paper, we fill this gap by developing a standard growth model with adverse selection. Our main results are that, by fostering unproductive investment, adverse selection: (i) leads to an increase in the economy's equilibrium interest rate, and (ii) it generates a negative wedge between the marginal return to investment and the equilibrium interest rate. Under financial integration, we show how this translates into excessive capital inflows and endogenous cycles. We also explore how these results change when limited pledgeability is added to the model. We conclude that both frictions complement one another and argue that limited pledgeability exacerbates the effects of adverse selection.

Suggested Citation

  • Alberto Martin & Filippo Taddei, 2010. "International Capital Flows and Credit Market Imperfections: a Tale of Two Frictions," Carlo Alberto Notebooks 160, Collegio Carlo Alberto, revised 2011.
    • Handle: RePEc:cca:wpaper:160
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    More about this item

    Keywords

    Limited Pledgeability; Adverse Selection; International Capital Flows; Credit Market Imperfections;
    All these keywords.

    JEL classification:

    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems

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