Capital Account Liberalization, Financial Frictions, and Belief-Driven Fluctuations

To investigate the macroeconomic effects of capital account liberalization, we apply a dynamic general equilibrium model with two production sectors. In contrast to the literature on belief-driven sunspot fluctuations caused by production externalities, our model does not assume any production externalities. In our model, agents face financial constraints and production heterogeneity. The financial constraints and agents’ production heterogeneity are sources of dynamic inefficiency. Although indeterminacy of equilibrium and belief-driven sunspot fluctuations never occur in the closed economy, dynamic inefficiency combined with a negative foreign asset in the steady state produces indeterminacy in the small open economy if financial constraints are fully relaxed under the condition that the investment goods sector is more labor intensive than the consumption goods sector