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Private inflows when crises are anticipated: a case study of Korea

  • Economics
  • Physics
  • Political Science


Dooley.PDF Private Inflows when Crises are Anticipated: A Case Study of Korea Michael P. Dooley University of California, Santa Cruz Inseok Shin Korean Development Institute I. Introduction The Korean crisis in 1997 illustrated again the fact that large capital inflows can be a mixed blessing. Liberalization of the capital account in Korea was associated with massive private capital inflows totaling about $120 billion from 1992 through mid 1997. The reversal of these flows in the second half of 1997 and throughout 1998 was even more dramatic and generated a devastating downturn of the economy. Why did capital inflows following liberalization turn out to be so dangerous? Although the pattern of liberalization, capital inflows and crisis has become familiar, the underlying mechanism among the three events is not fully understood. An often-raised argument is that macroeconomic risk associated with exchange rate misalignment is the fundamental cause of crises (E.g. Krugman 1979). But the Korean case adds one more counter-example against the argument along with the ERM crisis in 1992 and the Mexican crisis in 1994. In all these cases the external imbalance of the economy before the crisis was hardly alarming (e.g. Dooley and Chinn 1998, Shin and Hahm 1998). Recently, Dooley (1998) puts forward the insurance model as an alternative explanation for the mechanics behind massive capital inflows and crisis. The basic idea of the insurance model is that the microeconomics of financial intermediation and the government’s role in financial intermediation are the primary sources of crises. Crises in this framework are not related to changes in private expectations or to inconsistencies in macro regimes. Instead the policy inconsistency arises from the desire of governments to accumulate financial assets in order to smooth national consumption and the desire to insure the domestic financial system. The insurance model is particularly appealing

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