Financial Liberalization, Financial Development, and Macroeconomic Risks in an Open Economy

In an open economy with endogenous risks, financial development and capital account liberalization reduce the volatilities of home equity and bond prices, and appreciate the home currency at the stochastic steady state. Financial development lowers the equilibrium real interest rate when exchange rate floats and increases it when exchange rate is fixed. Capital account liberalization increases the real rate in both exchange rate regimes. Monetary policy should be countercyclical to the volatilities of home equity and bond prices, and procyclical to the volatilities of foreign bond price and exchange rate. Proper reactions to the risks make central banks less constrained by the Mundell-Fleming trilemma