We develop a model of a small open economy with credit market frictions to analyze the consequences of capital account liberalization. We show that financial opening facilitates the inflows of cheap foreign funds and improves production efficiency. Reforms increasing labor market exibility can further improve such efficiency gains. However, capital account liberalization also has important distributional consequences. Specifically, it may be impossible to use public transfers to fully compensate the loss of those negatively affected by capital account liberalization. This explains why financial opening often meets fierce opposition even though it leads to efficiency gains for the economy as a whole. From a practical perspective, capital controls should be lifted gradually for a smooth transition.
capital account liberalization, capital controls, financial frictions, macroeconomic fluctuations, asset price overshooting
Review of International Economics
ZHANG, Haiping and von Hagen, Jürgen.
A Welfare Analysis of Capital Account Liberalization. (2008). Review of International Economics. 16, (3), 576-590. Research Collection School Of Economics.
Available at: http://ink.library.smu.edu.sg/soe_research/423