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Liquidity constraints, international trade, and optimal monetary policy

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  • Ho Wai-Ming

    (Department of Economics, York University, 4700 Keele Street, Toronto, ON M3J 1P3, Canada, Phone: 416 736 2100 ext.22319. Fax: 416 736 5987)

Abstract

The availability of liquidity matters for an economy’s production and trade as firms need working capital to finance their operations. This paper studies the interaction between trade and capital flows operating through the liquidity allocations in the financial markets using a small-open-economy, overlapping-generations model. Working capital requirements distort the intratemporal consumption allocations. International capital inflows help easing liquidity in the domestic credit market, facilitating trade and improving the intratemporal allocation, while distorting the intertemporal allocation of the economy. We show how the government can use the Friedman rule and differentiated consumption taxes to address the tradeoff between the intratemporal and intertemporal distortions and achieve the second best optimum. Imposing a higher tax rate on imports can reduce the international borrowing to imports ratio and enhance the efficiency in using capital inflows to facilitate trade flows.

Suggested Citation

  • Ho Wai-Ming, 2020. "Liquidity constraints, international trade, and optimal monetary policy," The B.E. Journal of Macroeconomics, De Gruyter, vol. 20(2), pages 1-29, June.
    • Handle: RePEc:bpj:bejmac:v:20:y:2020:i:2:p:29:n:2
    DOI: 10.1515/bejm-2015-0203
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    More about this item

    Keywords

    excessive borrowing; Friedman rule; intratemporal and intertemporal trade; liquidity constraints; small open economy;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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