International Debt and the Price of Domestic Assets

This paper examines the behavior of indebtedness, consumption, and asset prices in a small open economy in which the foreign real interest rate depends not only on an exogenous world interest rate and on indebtedness, but also on the value of the capital stock, viewed as an implicit "collateral," and hence on the price of capital. The paper finds that the collateral effect magnifies the intensity of shocks to the economy and the duration of their impact. The collateral effect also generates additional distortions that could lead to overborrowing. The paper discusses the policy responses to these distortions.