Why are emerging economies excessively vulnerable to shocks to external funding? What was the role of financial flows from emerging to developed economies in setting the stage for the subprime crisis? This paper addresses these questions in a simple general equilibrium framework that emphasizes the aggregate implications of the misallocation of funds on the micro level.
The analysis shows that the misallocation of funds amplifies volatility even in a closed economy. Financial integration between relatively distorted emerging economies and relatively undistorted developed economies leads to a further divergence in volatility, thereby providing a new and simple explanation for the divergent trends in output volatility up to the recent crisis. In the integrated environment, cheap funding leads to an endogenous deterioration of the financial system in developed economies.
These predictions are consistent with a wide variety of microfoundations, in which distortions cause productive projects to be relatively more sensitive to aggregate shocks. The paper provides some empirical evidence for these microfoundations.
The patterns of global volatility over the last few decades have raised many questions regarding the consequences of globalization. For emerging economies, financial integration was typically associated with episodes of extreme volatility, often related to fuctuations in the supply of external funding. At the same time, for developed economies, fuctuations in the supply of funds did not seem to bean important source of volatility, at least not until the recent crisis1. Further, evidence suggests that the relative importance of non-technology shocks in developed economies was declining over the period of nancial globalization, as many attributed the \Great Moderation" trend in output volatility to a decline in nonfundamentalvolatility2. Why were the initial e ects of nancial integration so di erent for emerging and developed economies?
The picture is complicated further by the recent crisis, that suggests that the consequences of nancial integration on volatility in developed economies may
have been highly complex. While fuctuations in external funding were not an important driver of volatility during normal times, it seems that the magnitude of ows towards developed economies may have led to an over ow of the nancial system and a collapse from within. Many attribute the ampli cation of the crisis to the incapacity of the nancial system to withstand even relatively small shocks, a fragility that was an equilibrium outcome of a global environment that ooded the financial system with liquidity. Did the global supply of funds play a role in setting the stage for the sub prime crisis?
This paper takes the view that the aggregate implications of nancial distortions are central to these questions. I consider a model in which funding is the single input of production, and there are heterogenous projects. Distortions increase the sensitivity of relatively productive projects to aggregate fuctuations in the supply of funds. In reduced form, this type of misallocation can be represented as a less steeply declining aggregate marginal return to funds: in e cient economies, projects are implemented in an order decreasing in their returns. The aggregate marginal return to funds is decreasing, as less and less productive projects are funded as the supply of funds increases. In distorted economies, the order in which projects are implemented is less correlated with their productivity. The marginal return to funding declines less steeply, as relatively productive projects are implemented with the marginal units of funding, while relatively unproductive projects are implemented inframarginally.
I embed this reduced form representation distortions in a stylized general equilibrium model of nancial integration. I begin by studying the closed economy equilibrium, and illustrate a tight link between nancial distortions and aggregate output volatility. Shocks to the aggregate supply of funds are ampli ed by nancial distortions, as distortions increase the vulnerability of relatively productive projects to aggregate fluctuations.
Author:Eden, Maya;Document Date: 2012/01/01.Document Type: Policy Research Working Paper.Report Number:WPS5929
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