Macroeconomic and Welfare Implications of Capital Account Liberalization

It is well documented that since the mid-1980s there has been a surge in capital flows due to

an increased integration of world financial markets. Absent limited commitment, the increase

in financial linkages should improve risk-sharing opportunities. I use a small open economy

model where foreign lending to households is constrained by a borrowing limit motivated by

limited enforcement. Borrowing is secured by collateral in the form of durable investment

whose accumulation is subject to adjustment costs. In this economy an increase in the degree

of capital account liberalization increases consumption volatility as agents are unable to exploit

risk-sharing opportunities. In presence of risk averse agents an increase in financial integration

reduces welfare.