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Abstract

This paper studies the different tradeoffs between growth and volatility by both sides of capital flows on the basis of their different considerations of financial risks and levels of financial development. Since growth and volatility are negatively correlated, volatility must be kept low to derive high growth from capital flows when integrating into global markets. The reason why one side´s push for capital market opening encounters the other side´s reluctance is that the former may likely benefit from openness while the latter is unsure abouth the gains from financial liberalization due to its financial market imperfections. This conflict of interest is resolved as a bargaining equilibrium by making each side´s optimal tradeoff internationally compatible. Bargaining between the two sides with differeing valuations of capital flows leads to information revelation through strategic delays in financial liberalization which explains the many stylized puzzles such as the Feldstein-Horioka puzzle.