International adjustment in the face of imperfect financial markets

Traditional open economy models assuming efficient global financial markets cannot explain the incidence or severity of sudden crises such as those recently experienced in Mexico and East Asia. Thus this article presents a new model-one that can account for many characteristics of the recent crises. The model focuses on the information asymmetry between well-informed managers of local firms and banks and less-informed outside investors and shows that imperfect information severely hinders financial market transactions, with adverse effects on long-term economic development. The qualitative response of the model to financial and exchange rate shocks is analyzed and the response is compared with that of a perfect information model to see how well the new model accounts for aspects of the recent crises that are difficult to explain with traditional models. The model responds to a shock with a large initial downturn followed by a slow recovery. The development of effective financial intermediaries accelerates recovery, provides valuable institutional conduits for external financial support, and offers an effective means of deploying capital to its highest-return applications in support of longterm growth. Other interventions-most notably aggressively restrictive monetary policies designed to raise domestic interest rates-do more harm than good.