Abstract
The paper introduces a tractable capital market friction mechanism that allows a break of the parity between the domestic and external interest rates and generates a gradual evolution of capital stock, consumption, relative prices and the interest rate differential – in contrast to the instantaneous convergence found in models with interest rate parity. The friction, derived from explicit microfoundations, is such that the cost of new loans is an increasing function of net borrowing. The paper also presents a two-sector, open economy model of capital accumulation, where the friction mechanism is combined with standard assumptions about household preferences and production technology, which generates plausible dynamics of macroeconomic variables. JEL Classification Numbers: F41, F43
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