A welfare analysis of hot money

A welfare analysis of hot money
Document type
Guembel, Alexander; Sussman, Oren
Said Business School, Oxford University
Date of publication
3 April 2012
Saïd Business School Working Paper Series 2012-17
Trends: economic, social and technology trends affecting business
Business and management
Material type

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There is ample evidence that cross-country contagion of financial crisis is caused by short-term capital flows (hot money). It is sometimes used in order to justify a policy of restricting the integration of the world’s liquidity markets (fragmentation). In a model with underprovision of liquidity, contagion and excessively-high probability of financial crisis, we show that fragmentation has an ambiguous effect on welfare. Indeed, we show that when a country encloses liquidity into its own market it deprives its neighbour of liquidity, increasing the neighbour’s probability of financial crisis. Fragmentation may also imply that a country may “sit” on idle liquidity while its neighbour suffers from a financial crisis. Hence, there are conceivable circumstances where the welfare cost of fragmentation dominate the benefits,giving rise to “optimal contagion” in the second-best sense. Policy coordination plays an important role in our analysis.

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