Welfare Implications of Capital Account Liberalization

In recent decades, capital account liberalization in emerging economies has often been fol- lowed by a surge in capital inflows, despite the presence of severe informational asymmetries for foreign lenders. Empirical studies have shown that in emerging economies financial liberaliza- tion has led to an increase in consumption volatili ty (also relative to output). I use as mall open economy model where foreign lending to households is constrained by an endogenous borrowing limit. Borrowing is secured by collateral in the form of durable investment whose accumulation is subject to adjustment costs. This economy is able to replicate the aforementioned stylized fact in response to various shocks (productivity, foreign demand and government expenditure). I find that financial liberalization reduces welfare since it increases the volatility of consumption and employment. JEL Codes: E52, F1.