Structural Asymmetries and Financial Imbalances

Many southern European economies experience large capital inflows during periods of expansion that are followed by abrupt reversals when a recession hits. This paper studies the dynamics of capital flows between the North and South of Europe in a two-country DSGE model with incomplete international asset markets. Over the business cycle, the direction of capital flows between the two regions can be explained in a model in which common shocks have asymmetric effects on debtor and creditor economies. This mechanism explains why aggregate consumption is more volatile in the South than in the North and generates a higher welfare cost of business cycle fluctuations in the region that experiences procyclical net capital inflows. We also study the adjustment to asymmetric financial shocks.