Filippo Taddei

“International Capital Flows, Financial Frictions and Welfare”

abstract

The connection between the financial crisis of 2007-08 and global imbalances is controversial. We argue that the main reason why the relationship may be in place is due to the existence of financial frictions in domestic credit markets. We rationalize this point of view by developing a standard growth model where adverse selection and limited pledgeability coexist. We show that existence of financial frictions does not suffice in building the relationship between international capital flows and financial crisis, unless we give the center stage to adverse selection. We apply this observation to the analysis of the welfare effects of international capital flows and we show that these effects depend on the nature of financial frictions at the domestic level. Consequently, the appropriate policy response to international capital flows depends on the specific domestic nature of financial frictions.