Liquidity constraints, international trade, and optimal monetary policy

The availability of liquidity matters for an economy's production and trade as firms need working capital to finance their operations. This paper studies the interaction between trade and capital flows operating through the liquidity allocations in the financial markets using a small-open-economy, overlapping-generations model. Working capital requirements distort the intratemporal consumption allocations. International capital inflows help easing liquidity in the domestic credit market, facilitating trade and improving the intratemporal allocation, while distorting the intertemporal allocation of the economy. We show how the government can use the Friedman rule and differentiated consumption taxes to address the tradeoff between the intratemporal and intertemporal distortions and achieve the second best optimum. Imposing a higher tax rate on imports can reduce the international borrowing to imports ratio and enhance the efficiency in using capital inflows to facilitate trade flows.