Credit Market Frictions in an Open Economy

This paper assesses the effects of asymmetric information and agency costs in credit markets in an open economy with a floating exchange rate and sticky prices. A decline in agency costs lowers the cost of external finance and increases the long-run level of steady state investment, capital and output. Agency costs also affect the business cycle and the central bank's response to shocks in the economy. Following a supply (demand) shock to the economy agency costs dampen (magnify) output fluctuations. The results thus underline the importance of incorporating credit markets into macroeconomic models.