In the previous chapter we argued that the interplay between credit constraints and the equilibrium interest rate acts as a propagation mechanism for exogenous shocks and in certain cases has the potential to generate persistent fluctuations
One way of getting rid of this particular problem is to open the economy (including the capital market), so that the interest rate no longer varies in response to demand conditions in the domestic economy.
However, we argue in this chapter that financial liberalization introduces a new problem: Now the real exchange rate, which is the relative price between nontradable and tradable goods, becomes a source of instability. It goes up in a boom, squeezing profits, which limits borrowing and hence investment and brings the economy down. The fact that the economy is open to capital inflows may actually make things worse, since it allows investment demand to grow very fast in a boom.
The chapter is organized as follows. Section 4.1 lays out the model. Section 4.2 describes the basic mechanism, characterizes the conditions under which macroeconomic volatility arises, and derives a first set of predictions. Section 4.3 shows that these predictions are consistent with the existing empirical literature on lending booms. Section 4.4 analyzes the impact of a capital account liberalization. Section 4.5 draws some policy conclusions.
4.1