FINANCIAL INTERMEDICATION AND THE COST OF CAPITAL IN AN OPEN ECONOMY

This paper develops a dynamic general equilibrium model to assess the cost of financial intermediation in a small open economy with a floating exchange rate and sticky prices. Costly financial intermediation raises the cost of capital and lowers the long-run level of steady state output, capital and consumption. Following a shock to the economy the cost of borrowing from financial intermediaries increases by more than the rate of interest paid in public debt markets. But overall, the real effects of costly financial intermediation and a higher cost of capital are small.