Financial Integration, Capital Flight and the IMF

This paper develops a portfolio-balance model, to show that a currency crisis following capital flight can occur in an open economy without any dramatic shift in the underlying fundamentals. The crisis is of liquidity brought about by sudden withdrawals of foreign capital from the financial market. Once a crisis hits, the traditional IMF policy of austerity may not work and may in fact worsen the crisis. It is also possible that an economy at the border of equilibrium may be thrown into disequilibrium, if any of the restrictive policies are pursued. The instability is rooted in the formation of market perception of risk associated with tradable short-term assets. Perceived risk makes asset demand functions nonlinear, which is instrumental in determining whether financial markets are stable, and if an economy eventually returns to equilibrium when subjected to a shock.