Adjusting to Capital Account Liberalization

We study theoretically how the adjustment to liberalization of international…nancial transaction depends upon the degree of domestic …nancial development.Using a model with domestic and international borrowing constraints, we showthat, when the domestic …nancial system is underdeveloped, capital account lib-eralization is not necessarily bene…cial because TFP stagnates in the long-run oremployment decreases in the short-run. Government policy, including allowing for-eign direct investment, can mitigate the possible loss of employment, but cannoteliminate it unless the domestic …nancial system is improved.[...]