International capital flows under asymmetric information and costly monitoring: implications of debt and equity financing

The impact of increased equity trade on a small open economy is examined. Stochastic second-period output depends on first-period investment. Owing to information asymmetries, domestic agents cannot reveal credibly the level of first-period investment to international financiers. Consistent with recent proposals to strengthen the international financial system, domestic firms choose to incur self-monitoring costs to increase capital inflows. As an alternative to borrowing, domestic agents may sell ownership claims to second-period output. When equity claims convey information, equity trade is preferred to international borrowing, consistent with developing economies' observed reliance on international equity relative to debt in recent years.