Essays on optimal policy in open economies

University of Minnesota Ph.D. dissertation. August 2013. Major: Economics. Advisors: V.V. Chari and Patrick James Kehoe. 1 computer file (PDF); ix, 172 pages, appendices A-C.My dissertation consists of three chapters. The common theme that unifies the chapters is the analysis of how lack of commitment and enforcement frictions shape outcomes in dynamic economies and the implications that the existence of these frictions have for policy. In the first chapter, ``Efficient Sovereign Default,'' I show that key aspects of sovereign debt crises can be rationalized as part of the efficient risk-sharing arrangement between a sovereign borrower and foreign lenders in a production economy with informational and commitment frictions. I show that, under appropriate assumptions, the interaction between lack of commitment and private information gives rise to ex-post inefficient outcomes that exhibit many of the characteristics of sovereign debt crises in the data. Despite being ex-post inefficient, these outcomes are efficient from an ex-ante perspective because they help to provide incentives. To interpret these inefficient outcomes as debt crises, I show how the efficient allocation can be implemented as an equilibrium outcome of a sovereign debt game in which the set of securities that the sovereign government can issue is restricted to non-contingent defaultable bonds of multiple maturities. The implementation has implications for the optimal maturity composition of debt. Consistently with the data, as default is more likely, the maturity composition of debt shifts toward short term debt. In the second chapter, ``Credit Market Frictions and Trade Liberalization,'' joint with Wyatt Brooks, we investigate whether credit market frictions reduce gains from trade liberalization. We develop a dynamic, general equilibrium trade model with heterogeneous firms and consider two specifications of credit market frictions: collateral constraints as in Evans and Jovanovic (1989) and limited enforcement as in Albuquerque and Hopenhayn (2004). Though these two specifications have similar implications for firm-level dynamics, but they have different implications for trade reform. With limited enforcement there are the same percentage gains from trade liberalization as there would be in the presence of perfect credit markets; with collateral constraints the gains are lower. This is because the debt limits that firms face respond to profit opportunities in the first case and not in the second. Using firm-level panel data from a trade reform in Colombia, we find that the change in entry decisions in the export market after the reform is consistent with the limited enforcement specification. In the third chapter, ``Capital Mobility and Optimal Fiscal Policy without Commitment: A Rationale for Capital Controls?,'' I study a Ramsey taxation model for a small open economy. A known result in the literature is that if the government has commitment, there is no need to introduce capital controls. In contrast, I show that when the government lacks commitment, imposing capital controls on inflows is necessary to support the efficient allocation when the economy is capital scarce. In this chapter I abstract from uncertainty. The model, augmented with shocks to productivity and the international interest rate, offers a framework for studying how the government should respond to shock to the international interest rate, and how the differential between domestic and foreign capital income taxes moves over the cycle