The Impact of Financial Frictions on a Small Open Economy: When Current Account Borrowing Hits a Limit

The evidence of the last 20 years of recurring output busts and rapid reversals of the current account in emerging markets indicates that domestic agents may not be able to borrow in international capital markets to fully insure themselves against internal and external shocks. This paper models this phenomenon as a form of excess volatility by introducing a financial friction into a stochastic model of a small open economy. The financial friction limits the current account deficit to a fixed fraction of gross domestic product. The paper shows that conditional volatility and asymmetry are significant statistical characteristics of the GDP and current account that reflect the excess volatility and the current account reversals. The economic model can explain the conditional volatility and asymmetry of Mexican GDP and the current account.