Capital flows under moral hazard

I analyze a model with moral hazard and limited enforcement in a small open economy. I find that when state contingent contracting is allowed adding the moral hazard friction improves the model's predictions along several dimensions. First, it justifies why non-contingent debt is an optimal way to finance an emerging economy. Second, it explains the limited consumption risk-sharing and high, volatile and counter-cyclical interest rates. Third, it generates realistic crisis-like dynamics in which capital inflows are brought to a halt and interest rates sky-rocket. The model also has a strong internal propagation mechanism. Limited enforcement friction, alone or together with moral hazard, has nearly no effect on the model's performance. I also construct a simple empirical test to distinguish between the two frictions and it favors moral hazard over limited enforcement friction. (c) 2012 Elsevier B.V. All rights reserved.