Bank Credit, Portfolio Selection, and Macrodynamics in a Small Open Economy

ABSTRACT We propose an open macroeconomic model based on Bernanke and Blinder's credit perspective. We assume a small open economy with imperfect capital movement and substitutes for financial assets under a floating exchange rate system. We represent credit creation mechanisms and investigate the impact of financial factors on the home economy. We find that the difference in relative responses of banks and firms to the profit rate is associated with short‐term economic fluctuations and long‐term economic stability. Finally, we examine the effects of an inflation targeting policy, signifying that the central bank must gain credibility for its monetary policy to achieve stability.