Adjusting to capital liberalization

We study theoretically how an economy adjusts to liberalization of interna-tional financial transaction. We consider an economy in which debtors do not repay unless the debts are secured by collateral, and collateralizable assets for international borrowing are more restricted than domestic borrowing. We exam- ine how the adjustment to capital liberalization depends upon the domestic and international collateral constraints. We show that, with an intermediate level of domestic collateral constraint, capital liberalization leads to capital out‡ow, im- provement of TFP, and transitional loss of wage and employment. Government policy can mitigate the loss of workers at the cost of prolonging the transition, but cannot eliminate the loss without halting the transition.