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The purpose of this study is to examine a dynamic, stochastic, general equilibrium framework with financial and informational frictions and foreign borrowing in the case of money growth and technology shocks for a small open economy and to analyze the implications of varying degrees of financial integration for aggregate fluctuations and propagation mechanisms in the economy. The existence of informational asymmetries among the agents in the model necessitates financial intermediation in the economy. Moreover, there is uncertainty involved in the production process which leads to collateralized borrowing by firms and, therefore, has to be taken into account in the design of the loan contracts between firms and financial intermediaries. It is shown that increasing financial integration amplifies the effect of a positive, temporary monetary shock on output, consumption, investment, labor demand and loans; whereas it has barely any implication for the impact of a positive, temporary technology shock on the economy.

The business cycle implications of financial frictions have long been investigated in the literature1. This study proposes a theoretical framework to examine aggregate fluctuations and propagation mechanisms under increasing financial integration (captured by decreasing financial frictions) for a small open economy, contributing to the existing literature through taking into account financial and informational frictions and uncertainty.2 Financial frictions in the model are in the form of restrictions on the composition of deposits held by the financial intermediaries in the economy. More specifically, financial intermediaries are assumed to be able to hold no more than a certain fraction of their total deposits as foreign deposits. An increase in this fraction is interpreted as increasing financial integration. Informational asymmetries among the agents in the economy and uncertainty in the production process necessitate financial intermediation and require special attention to the design of the loan contracts between borrowers (firms) and lenders (financial intermediaries). In this study, a dynamic, stochastic, general equilibrium (DSGE) framework that incorporates financial integration is developed in order to analyze the sensitivity of the response of a small open economy to money growth and technology shocks under varying degrees of financial integration.3 The model developed here is one of cash in advance (CIA), similar in spirit to that by Cogley and Nason (1994), modified in such a way that it incorporates financial integration. The economy consists of households, firms, foreign lenders, financial intermediaries, the central bank and the financial regulator. It is shown that increasing financial integration amplifies the effect of a monetary shock on output, consumption, investment, labor demand and loans, while it has barely any implication for the impact of a technological shock on the economy. The economy analyzed in this paper features imperfections of the Holmstrom and Tirole (1997) type of uncertainty in the production process, financial frictions restricting the amount of foreign borrowing in the economy, and informational asymmetries among the agents in the economy. Entrepreneurs that run the firms can choose between two different projects for production, both of which are subject to idiosyncratic risk. The projects yield positive output in the case of success and no output in the case of failure. The projects differ according to their probabilities of success and the private benefits they provide to the entrepreneurs. It is those private benefits that create incentives for the managers of the firms, inducing them to act against the interest of their creditors. The project choices of the entrepreneurs are private information, whereas the project outcomes are verifiable by the financial intermediaries. Households and foreign investors are assumed to lack the ability to verify the project outcomes. Therefore, domestic and foreign investors prefer lending to firms indirectly, through financial intermediaries, rather than directly. Financial integration has become an increasingly attractive topic in both theoretical and empirical literature over the last couple of decades. This is partly because of its interaction with macroeconomic fundamentals and partly due to its contradictory consequences, especially for emerging economies. On the one hand, it provides emerging economies with the funds that might be used to realize investment opportunities. On the other hand, it exposes them to increasing financial vulnerability against external shocks since the financial infrastructure in such economies is not adequately developed. Financial integration is interpreted here as the process resulting from the reduction in financial frictions that prevent capital from freely flowing across international borders. The impact of financial integration on economic growth, macroeconomic volatility, the effectiveness of government policy rules depends on many factors including the structure of the financial system, the quality of financial supervision and regulation, the soundness of financial institutions, and the rapidity of the integration process.4 Financial integration is incorporated into the model through the introduction of a regulation in the economy that the financial intermediaries can hold no more than a certain fraction of their total deposits as foreign deposits. The parameter representing this fraction is assumed to be controlled by the financial regulator in the economy. This study aims to uncover the changes in the fluctuations in a small open economy in response to one-time, temporary technology and money growth shocks, if there are any, under varying degrees of financial integration. In other words, whether the degree of financial integration plays a role at all in the performance of the economy in response to technology and money growth shocks is investigated. The empirical literature on the issue of financial liberalization has rather ambiguous findings regarding the impact of increasing financial openness on the economic performance of countries.5Arteta et al. (2003) point out the high sensitivity of the issue of financial integration to the context, the framework in which it is analyzed, as far as its implications for countries are concerned. The authors find evidence for a positive association between financial liberalization and economic growth only under certain conditions; namely, OLS estimation with Quinn (1997) measure of financial openness. In a more recent study, Kose et al. (2006) emphasize the fact that there is still little robust evidence for growth benefits of broad financial liberalization, but that equity market liberalizations are shown to significantly boost growth. Furthermore, it is argued that the indirect effects of financial globalization on financial sector development, institutions, governance and macroeconomic stability are likely to be more crucial than direct effects through capital accumulation or portfolio diversification. In a follow-up paper, Kose et al. (2011) argue that there are certain “threshold” levels of financial and institutional development that an economy needs to attain in order to be able to enjoy the benefits from financial liberalization.6Alper and Cakici (2009) analyze the impact of increasing financial liberalization on economic growth using a panel data set of 75 countries covering the period 1980–2003. Authors show that financial liberalization has significantly positive effect on economic growth only when it is accompanied by fiscal prudence, which is proxied by overall budget balance. Sensitivity of the implications of financial integration as a topic to context and methodology creates room for research and contribution to the literature in the form of providing new frameworks to investigate it, which constitutes also the motivation of this study. Among the theoretical studies on financial integration, Buch et al., 2005 and Senay, 1998 and Sutherland (1996) are, in a sense, similar to this study in terms of their motivation to analyze financial integration; namely, to investigate the business cycle implications of financial integration in the presence of certain shocks. Sutherland (1996) models the process of financial integration in an intertemporal general equilibrium framework as the elimination of trading frictions between financial markets in different countries. Sutherland shows that increasing financial market integration increases the volatility of a number of variables when shocks originate from the money market, but decreases the volatility of most variables when shocks originate from real demand or supply. The author suggests that the results could change in response to relaxing the assumption of perfect goods market integration. Senay (1998) investigates how increasing financial and goods market integration changes the effectiveness of fiscal and monetary policy. Senay analyzes expansionary monetary and fiscal policies under different degrees of goods and financial market integration in a dynamic general equilibrium framework. Senay finds that increasing financial integration increases the effectiveness of monetary policy while it decreases that of fiscal policy. It is argued by the author that these effects arise from the interaction between relative asset returns and the exchange rate. Buch et al. (2005) develop a theoretical model based on that by Sutherland to derive empirically testable hypotheses on how financial market integration might influence the impact of macroeconomic shocks on business cycle volatility. They show that the link between financial openness and business cycle volatility depends on the nature of the underlying shock. More specifically, they find that increasing financial openness magnifies output volatility in the presence of monetary, productivity and risk premium shocks. The model economy employed in these studies consists of households, firms and government. Financial integration is captured through introduction of adjustment costs that households have to face while transferring funds from domestic bond market to foreign bond market. Reduction in these costs implies increasing financial integration. The novelty of this paper here is the provision of a framework incorporating also financial intermediation for the analysis of financial integration, which is then used to analyze the response of the economy to money growth and technology shocks under varying degrees of financial integration. The degree of financial integration is captured here as the fraction of total deposits financial intermediaries hold as foreign deposits. As far as models with financial intermediation are concerned, there is a literature following Kiyotaki and Moore (1997) designing the loan contracts between borrowers and lenders with some durable asset, like land, as collateral.7 In these models, lenders cannot force borrowers to repay debts unless those debts are secured. In such a context, borrowers’ assets like land serve both as factors of production and as collateral for new loans. Kiyotaki and Moore (1997) employ such a framework in the dynamic equilibrium model they develop in order to analyze the transmission mechanism in the case of temporary shocks. Kiyotaki and Moore show that small, temporary shocks to technology or income distribution can generate large, persistent fluctuations in output and asset prices.8 Another study employing land as collateral by von Hagen and Zhang (2008a) investigates the welfare implications of financial liberalization in a real, small open economy and suggests that financial opening facilitates the inflow of cheap foreign funds and improves production efficiency. The uncertainty involved in the production process requires also in this framework here special attention to the design of the loan contracts between the firms and the financial intermediaries. However, in the current framework, it is the capital stock of the firms that is suggested to be used as collateral by the firms in the case of failure of their projects. Therefore, the loan contracts specify the rate of interest on loans that is going to be valid in the case of success and the fraction of the capital stock of the firms to be handed over to the financial intermediaries in the case of failure. In this context, the output produced by the firms using capital and labor as inputs is the return of the projects in the case of success. It is assumed that there is no output in the case of failure. Due to this probability of zero output in the case of failure, firms have to use their capital stock as collateral in order to be able to borrow loans from financial intermediaries. Discussions regarding the contribution of technology shocks to business cycles have been controversial since the pioneering work by Kydland and Prescott (1982).9 It has been argued that the contribution of technology shocks to aggregate fluctuations depends on several factors including the extent of imperfect competition, external economies of scale, overtime wage premiums and measurement errors in labor input and output, as also pointed out by Aiyagari (1994). Consequently, in order to be able to determine the exact contribution of technology shocks to business cycles, precise quantitative measures of these factors would be required.10 In this paper, the implications of both technology shocks and monetary shocks for aggregate fluctuations are examined taking into account the potential impact of degree of financial integration. The rest of the paper is structured as follows: Section 2 describes the model and presents the solution of the model that consists of the system of equations including the first order conditions and the market-clearing conditions. The welfare cost calculation of financial frictions, the summary statistics, the simulation of the model, the impulse response functions and the sensitivity analyses are given in section 3. Finally, section 4 comprises the concluding remarks.

In this paper, aggregate fluctuations and propagation mechanisms under varying degrees of financial integration are analyzed for a small open economy. Using a dynamic, stochastic, general equilibrium framework with financial and informational frictions and uncertainty, the implications of increasing financial integration for the impact of money growth and technology shocks on the economy are investigated. Financial frictions in the model are in the form of restrictions on the composition of deposits held by the financial intermediaries in the economy. More specifically, financial intermediaries are assumed to be able to hold no more than a certain fraction of their total deposits as foreign deposits. An increase in this fraction is interpreted as increasing financial integration. Informational asymmetries among the agents in the economy and uncertainty in the production process necessitate financial intermediation and require special attention to the design of the loan contracts between the firms and the financial intermediaries. The Holmstrom-Tirole type of uncertainty in the production process leads to collateralized borrowing by the firms, where the capital stock of the firms serves as the collateral as well as the factor of production. Financial frictions have long been investigated in the literature in terms of their business cycle implications. Especially over the last two decades, theoretical progress as a result of the developments in economics of information and incentives made it possible to analyze asymmetries and imperfections in financial markets. The literature has focused on a wide array of issues related to financial frictions such as the way financial frictions are captured, the financial infrastructure of the economies featuring those frictions and the interaction between those frictions and other imperfections in an economy. This study contributes to the existing literature by proposing a new theoretical framework to examine aggregate economic activity and amplification mechanisms in the case of decreasing financial frictions (defined here as increasing financial integration), taking into account informational asymmetries and uncertainty in production. The small open economy DSGE model developed here is solved and simulated in the case of one-time, temporary, positive money growth and technology shocks. The model predicts an expansion in output, consumption, investment, labor demand and loans in response to a monetary shock; whereas a technology shock leads to an increase in output, investment, domestic deposits, loans, labor demand and net exports, and a decrease in consumption. The simulation experiments with different levels of financial integration reveal that increasing financial integration amplifies the impact of temporary monetary shocks on output, consumption, investment, labor demand and loans. The amplification effect of increasing financial integration is due to the mechanism in which the output-promoting impact of positive monetary injection is coupled with increasing access to cheaper foreign funds that enhance production through leading to a rise in loanable funds available for firms. The increase in the amount of funds available for firms due to a positive monetary injection leads to a rise in the amount of loans actually given to the firms through a fall in the loan rate, which is stimulated further by increasing financial integration that raises the volume of cheaper foreign funds held by financial intermediaries. The effect of increasing financial integration in the case of temporary technology shocks is found to be rather negligible. The sensitivity analyses undertaken for varying values of parameters of interest reveal that the results regarding the impact of temporary monetary and technology shocks on a small open economy are similar for small variations of the parameter values. The model presented here confirms, in a monetary framework, the findings of the real business cycle literature on small open economies and the empirical regularities typical of open economies in terms of the procyclicality of investment and consumption, and the countercyclicality of external trade. In addition, a positive correlation between savings and investment is found in the case of technology shocks under imperfect capital mobility, which is also consistent with the results of the benchmark framework in the business cycle literature for small open economies. Analyzing the impact of monetary shocks on the economy under varying degrees of financial integration allows one to gain insights into the design of optimal monetary policy in the case of varying levels of financial integration. This might have crucial implications especially for emerging economies, for most of which the process of financial liberalization has not yet been completed. Moreover, the current framework might be extended such that business cycle implications of other shocks such as interest rate or risk premium shocks as well as fiscal policy implications can be analyzed for small open economies, as far as future research possibilities are concerned.