Sources of debt accumulation in a small open economy

It is widely believed that developing countries borrowed heavily on international financial markets based on the perception that the favorable external environment (low world interest rates and increasing commodity prices) of the 1970s would last. But, the commodity price booms of the mid- and late 1970s were short-lived and the period of low interest rates ended by the early 1980s. To what extent did uncertainty about the external environment contribute to developing countries' debt accumulation? It is reasonable to believe that their borrowing behavior will depend crucially on the perceived longevity of shocks. This paper analyzes the borrowing behavior of a small open economy that is subject to terms of trade and world interest rate shocks in an environment where policy makers face uncertainty about the longevity of shocks. In particular, the analysis focuses on the conditions under which an optimistic view (that is alleged to have prevailed among developing countries during the debt accumulation period) about the longevity of external shocks, leading to overestimating the longevity of positive external shocks or underestimating the longevity of negative external shocks, can lead to significant debt accumulation. It is found that this optimistic view is compatible with rational behavior and can generate persistent overborrowing, making debt accumulation likely.