Financial Openness, Financial Frictions, and Macroeconomic Fluctuations in Emerging Market Economies

ABSTRACT

This article develops an open economy DSGE model which takes into account the effects of financial openness and the associated financial frictions on macroeconomic fluctuations by introducing a modified version of interest parity. Evidence from the Chinese economy shows that the model provides a reasonable description of China’s financial openness and financial frictions during the sample period. Further evidence from comparative analysis shows that in most cases an increase in financial openness, usually accompanied by a decrease in financial frictions, leads to flatter volatility patterns with respect to domestic shocks but sharper volatility patterns in the presence of foreign shocks.

KEY WORDS:

• financial openness
• financial frictions
• macroeconomic fluctuations

Acknowledgments

The author would like to thank the editors and the anonymous referees for their helpful comments and suggestions.

Notes

1. In a framework similar to Edwards and Khan (1985), Ahn (1994) presents a model of the determination of the interest rate and exchange rate for a small economy with different degrees of capital mobility.

2. A sample of 100,000 draws is sufficient to ensure convergence of the Metropolis-Hastings sampling algorithm according to multivariate and univariate diagnostics.

Additional information

Funding

The research is supported by the National Natural Science Foundation of China (Grant No. 71403277) and National Social Science Foundation of China (Grant No. 12&ZD089).