Capital flowsundermoralhazard

I analyzeamodelwithmoralhazardandlimitedenforcementinasmallopeneconomy. I findthatwhenstatecontingentcontractingisallowedaddingthemoralhazardfriction improvesthemodel’spredictionsalongseveraldimensions.First,itjustifieswhynon- contingentdebtisanoptimalwaytofinanceanemergingeconomy.Second,itexplains thelimitedconsumptionrisk-sharingandhigh,volatileandcounter-cyclicalinterestrates. Third,itgeneratesrealisticcrisis-likedynamicsinwhichcapitalinflowsarebroughtto a haltandinterestratessky-rocket.Themodelalsohasastronginternalpropagation mechanism. Limitedenforcementfriction,aloneortogetherwithmoralhazard,hasnearlynoeffect on themodel’sperformance.Ialsoconstructasimpleempiricaltesttodistinguishbetween thetwofrictionsanditfavorsmoralhazardoverlimitedenforcementfriction