International Credit Flows and Pecuniary Externalities∗

latest version: [click here] This paper develops a dynamic two-country neoclassical stochastic growth model with incomplete markets. Short-term credit flows can be excessive and reverse suddenly. The equilibrium outcome is constrained inefficient. First, an undercapitalized country borrows too much since each individual firm does not internalize that an increase in production capacity undermines their output price and thereby worsens their terms of trade. From an ex-ante perspective each firm undermines the natural “terms of trade hedge. ” Second, sudden stops and fire sales lead to sharp price drops of illiquid physical capital, another pecuniary ex-ternality. The analysis also provides a full characterization of the endogenous volatility dynamics and welfare. Imposing capital controls or other domestic macro-prudential policy measures that limit short-term borrowing can improve welfare