CAPITAL FLOW AND BANK LENDING CHANNELS IN A SMALL OPEN ECONOMY: EVIDENCE FROM INDONESIA

This paper investigates the implications of macro-financial linkages in explaining the interaction of the financial and business cycles as the primary contributor to understanding the fluctuations in the Indonesian economy. It attempts to capture the interaction of the global financial and domestic business cycles through portfolio flow by incorporating investor behavior through a preference for domestic asset classes. Furthermore, due to information asymmetries between lenders and borrowers, we include the monitoring cost to explain the transaction cost in the credit market as a factor that drives macroeconomic fluctuations. Our findings demonstrate how financial imperfections can amplify the impact of global financial cycles on domestic business cycles. The demand for riskier investment illustrates how risk-taking behavior impacts capital flow and contributes to the endogenous amplification of the economic cycle.