International capital flows, debt overhang and volatility

Abstract

This paper shows how international capital flows originate boom-bust and sunspot episodes in a neoclassical growth model of a small, open economy. A limit is imposed on how much the economy can borrow from foreign creditors and it is made endogenous by assuming that the debt-to-GDP ratio is procyclical. The steady state is locally indeterminate when the credit multiplier is larger than some threshold level, whereas saddle-point stability prevails when the credit multiplier is low enough. As a consequence, high levels of the credit multiplier lead to both booms followed by busts and sunspot-driven volatility near the steady state, while, in contrast, low levels ensure monotonic convergence. Compared with saddle-path equilibria, boom-bust and sunspot equilibria are associated with both lower welfare and debt overhang, that is, a crowding-out effect of credit: when the economy is highly leveraged, it uses savings to cut down foreign debt, at the expense of both human and physical investment. Numerical examples show that indeterminacy arises for debt-to-GDP ratios that fall within the range of available estimates. Finally, the effects of shocks to the world interest rate on output and consumption are amplified and persistent in the debt overhang regime.