Intermediation of International Capital Inflows and Macroeconomic Fluctuations in Emerging Market Economies

Abstract

This study investigates the macroeconomic implications of financial intermediation of international capital inflows in a small open economy (SOE). The interplay between financial intermediation and macroeconomic fluctuations is studied under alternative representations of the relationship between international lenders, banks, and domestic borrowers, following two typical approaches in the banking literature. Under the industrial organization approach, a model with neoclassical banks is unable to reproduce the large output swings associated with capital outflows observed in actual emerging economies. Furthermore, the volatility of domestic financial variables is consistent with actual statistics only when banks' supply of funds has a finite elasticity. Modelling banks under the incomplete information approach permits incorporation of aggregate risk into the analysis. Under this setting, banking crises are driven by undamentals, and both capital inflows and country-specific interest rates are endogenous and important in explaining domestic fluctuations. The study ends with a detailed explanation of how to use numerical methods to solve linearized models like the model with neoclassical banks.