This dissertation studies the mechanism through which international capital flows are transmitted from the banking sector to the real sector in a bank-based open economy when moral hazard problems are present. It also examines the role of the quality of institutions and domestic policies in reducing moral hazard problems and in determining the net benefit of international capital flows to a country. A general equilibrium model, incorporating moral hazard problems at the bank, corporate and international levels, is developed to explain this mechanism. In this unifying model, the three layers of moral hazard problems and international capital flows reinforce one another to amplify the boom-bust cycle of an economy, as seen in several crisis countries. The model predicts that an economy will never reach a steady state when banks can accumulate losses and finance those losses through foreign borrowing. This prediction underlines the role of international capital flows and the moral hazard problems at the bank and international levels in destabilizing an economy. The results from the parameter estimation and the hypothesis testing using Thailand data suggest that there have been structural changes in the quality of institutions and domestic policies after the Asian financial crisis and these changes help alleviate the moral hazard problems at all levels in Thailand. Based on the simulation exercises, the improvement in banking supervision and foreign investors' risk estimation helps substantially reduce the bailout costs and the output losses during the recession. In contrast, the reduction in government subsidies or tax incentives hurts, rather than helps, the economy since the cost from the overall output decline outweighs the benefit from the lower bailout costs.