The Lending Channel in a Small Open Economy Under Predetermined Exchange Rates The lending channel in a small open economy under predetermined exchange rates

Preliminary Draft Comments welcome This paper studies the role of banks in the propagation of nominal shocks in a small open economy. It builds on the framework developed in Edwards and Végh (1997), by relaxing the assumption of perfect asset substitutability between foreign and local bonds. The main results are as follows. Financial liberalization induces a decrease in loan spreads, an expansion in the volume of bank credit, and a decrease in the local bond's risk premium. An increase in foreign interest rates, in required reserves, or in exchange rate depreciation, generate exactly the opposite.