Capital Flows in a World Starved for Liquidity: Analysis and Policy Implications

We propose a framework for studying financial and macroeconomic dynamics in an environment where liquid assets have a productive use but their supply is limited (i.e., the economy is starved for liquidity). The private demand for financial assets arises from the need to hold them for production. The private supply of financial assets is limited and unstable because of borrowing constraints and default risk. We discuss open-economy applications that analyze the accumulation of foreign reserves by emerging economies, the increase in public debt issued by advanced economies, the rapid growth of emerging economies, structural changes in financial markets, and financial globalization. A key result is that most of these developments led to a decline in interest rates and an increase in global macroeconomic volatility, driven by riskier borrower portfolios.