A post-Keynesian model of the balance of payments crisis

The aim of this chapter is to understand the international dimension of the crisis in small open economies, which experienced persistent current account deficits before the global financial crisis. We develop a theoretical framework to explain the role of capital inflows in creating economic booms in a small open economy with sovereign currency. We demonstrate the destabilizing effects of capital inflows on the economy. We conclude that large speculative inflows generate debt-led booms, which are not sustainable in the long run. The episode of boom is followed by a bust, which is usually stronger in magnitude than the preceding boom. In particular, sovereign regimes are easily destabilized due to currency risk premiums and large trade balance effects. However, they also have the potential to adjust more rapidly owing to exchange rate flexibility, capital control and autonomous restructuring of the financial sector