NBER Working Paper No. 6007
The conventional wisdom is that capital flows between developing countries and developed countries are more volatile than can be justified by fundamentals. In this paper we construct a simple model in which frictions in international financial markets in combination with standard debt-default problems lead to volatile capital flows. These flows act as tests of fire for borrowing countries. If a country survives this test, its reputation is enhanced and future capital flows become less volatile. Failing this test is associated with a loss of reputation and a decline in the amount of capital flows.
Published: Chari, V.V. and Patrick J. Kehoe. "Hot Money," Journal of Political Economy, 2003, v111(6,Dec), 1262-1292.