ENSAYOS - Banco de la República

A Model of Credit, Financial Repression and Capital Flows
Leonardo Villar Gómez *
David M. Salamanca Rojas **
The views expressed in this paper are exclusively of the authors and do not represent those of the Banco de la República
or its Board of Directors. We thank Juanita Téllez for her suggestions during the elaboration of the model. We are also
thankful to Eduardo Lora, Hernán Rincón, Fernando Tenjo, Hernando Vargas and an anonymous referee for their comments
on a previous version of this paper. Any remaining mistakes are our own.
* Banco de la República. Member of the Board of Directors. E-mail: lvillago@banrep.gov.co
** Banco de la República. Financial Stability Analyst. E-mail: dsalamro@banrep.gov.co
Document received march 18 th 2005; final version accepted 19 th 2005.
Abstract
This paper develops a macro model with microeconomic foundations of the credit market in a small
open economy. The model identifies the channels trough which the financial sector can propagate and
amplify the shocks induced by fluctuations in the world financial markets. These findings are widely
consistent with the empirical evidence for the Colombian economy in recent years, in particular with
the strong positive correlation observed between domestic credit and capital flows. The model also
suggests that the pursuing of an active countercyclical policy of reserve requirements, such as that
recommended by Edwards and Vegh (1997), can be ineffective to insulate the domestic economy from
the external shocks and may have a perverse effect over some agents of the economy.
JEL Classification: E51, E58, F32, F41.
Key words: Capital flows, domestic credit, financial repression.
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