Money, Real Exchange Rates, and Capital Accumulation in a Small Open Economy with Financial Market Frictions

We consider a small open economy that produces and consumes two goods, one tradable and one not. Domestic residents combine their own income with credit obtained either abroad or at home to invest in capital production, which requires the tradable good. Capital investments in the tradable sector are subject to a costly state verification (CSV) problem, and the associated bank loans are subject to a binding reserve requirement. Under one technical condition, the presence of these financial market frictions leads to the existence of two steady state equilibria: one with a relatively high real exchange rate and a relatively low level of output, and one with a relatively low real exchange rate and a relatively high level of output. An increase in the world interest rate has an ambiguous effect on the real exchange rate in the low-output steady state, while output necessarily declines. In the high-output steady state, an increase in the world interest rate necessarily results in a decline in the real exchange rate, while the effect on output is ambiguous. An increase in the domestic money growth rate or the reserve requirement increases the real exchange rate and decreases the level of output in the low-output steady state, but decreases the real exchange rate and increases the level of output in the high-output steady state. At the same time, sufficiently large increases in the rate of money growth or the world interest rate can transform the high-output-low-real-exchange-rate steady state from a sink to a source. Thus while small increases in the interest rate or the money growth rate may be conducive to higher long-run levels of real activity, excessive increases can induce a kind of "crisis". This finding accords well with an array of empirical evidence. Finally, the model delivers a set of prescriptions for what a small open economy can do to protect itself against a "crisis" induced by rising world interest rates.