Quantitative implications of a debt-deflation theory of Sudden Stops and asset prices

https://doi.org/10.1016/j.jinteco.2005.06.016Get rights and content

Abstract

This paper shows that the quantitative predictions of an equilibrium asset-pricing model with financial frictions are consistent with key features of the Sudden Stop phenomenon. Foreign traders incur costs in trading assets with domestic agents, and a collateral constraint limits external debt to a fraction of the market value of domestic equity holdings. When this constraint does not bind, standard productivity shocks cause typical real-business-cycle effects. When it binds, the same shocks cause strikingly different effects depending on the leverage ratio and asset market liquidity. With high leverage and a liquid market, the shocks force “fire sales” of assets and Fisher's debt-deflation mechanism amplifies the responses of asset prices, consumption and the current account. Precautionary saving makes these Sudden Stops infrequent in the long run.

Introduction

A significant fraction of the literature dealing with the emerging markets crises of the last ten years focuses on an intriguing phenomenon referred to as a “Sudden Stop”. A Sudden Stop is defined by three stylized facts: sudden, sharp reversals in capital inflows and the current account, large declines in absorption and production, and collapses in real asset prices and in the price of non-tradable goods relative to tradables.

Table 1 summarizes the stylized facts of Sudden Stops using quarterly data from the IMF for four well-known cases: Mexico 1994, Argentina 1995, Korea 1997 and Russia 1998. In the Mexican crisis, real equity prices in units of the CPI fell by 29 percent, the current account rose by 5.2 percentage points of GDP, industrial output fell nearly 10 percent and consumption declined by 6.5 percent. Argentina's 1995 “Tequila” crisis resulted in collapses in real equity prices and industrial output similar to Mexico's, a current account reversal of 4 percentage points of GDP, and a decline in consumption of 4 percent. The Korean and Russian crises stood out for their large current account reversals of 11 and 9.5 percentage points of GDP, respectively, and for the widespread contagion across world financial markets. Equity prices fell simultaneously across emerging markets in South East Asia in 1997, even in countries where there was no devaluation of the currency, as in Hong Kong where equity prices fell by 20 percent.

Since the current account reversals that occur during Sudden Stops reflect an emerging economy's loss of access to international capital markets, there is growing consensus on the view that financial frictions are important for explaining Sudden Stops. Several theoretical studies have shown how a variety of financial frictions could potentially explain this phenomenon.1 In contrast, the quantitative predictions of this class of models are largely unknown. In particular, there is little evidence showing whether the effects of financial frictions are strong enough to account for the observed empirical regularities of Sudden Stops. Moreover, the current account reversal itself is modeled often as an exogenous shock rather than as an endogenous outcome of financial frictions (see for example Calvo, 1998). Hence, it is yet unknown whether this class of models can produce endogenous Sudden Stops caused by the standard underlying sources of business cycles in emerging markets, without relying on large, unanticipated shocks that impose the loss of access to capital markets by assumption. This paper attempts to address these issues by studying the quantitative predictions of an equilibrium asset-pricing model with financial frictions in which Sudden Stops are an endogenous response to productivity shocks identical to those that drive a frictionless real-business-cycle model.

The model considers two financial frictions widely used in studies of emerging markets crises (see the survey by Arellano and Mendoza, 2003): (1) collateral constraints, in the form of a margin requirement that limits the ability of agents to leverage foreign debt on domestic asset holdings, and (2) asset trading costs, intended to capture the effects of informational or institutional frictions affecting the ability of foreign traders to trade the equity of emerging economies (see Frankel and Schmukler, 1996, Calvo and Mendoza, 2000b). Collateral constraints and trading costs interact with the mechanisms at work in RBC models of the small open economy and equilibrium asset-pricing models with frictions: uncertainty, risk aversion and incomplete insurance markets.

The transmission mechanism that causes Sudden Stops in the model operates as follows. When the economy's debt is “sufficiently high”, an adverse productivity shock of standard magnitude has an effect that it does not have in other states of nature: it triggers collateral constraints on domestic agents. How high debt needs to be for this to occur is an endogenous outcome of the analysis. If the asset market is liquid, in the sense that the asset holdings of domestic agents are above short-selling limits, collateral constraints force domestic agents to fire-sell assets to foreign traders. These traders are slow to adjust their portfolios because of trading costs, and as a result asset prices fall. The price fall sets in motion Fisher's debt-deflation mechanism, as domestic agents engage in further fire sales of assets to comply with increasingly tight collateral constraints.2 At high leverage ratios (i.e., high ratios of debt to the market value of equity), these fire sales cannot prevent a correction in the economy's net foreign asset position, and as a result the price decline is accompanied by reversals in consumption and the current account. Thus, a Sudden Stop takes place.

The analysis of the above financial transmission mechanism as a feature of a dynamic, stochastic general equilibrium model is difficult because equilibrium asset prices are forward-looking objects that represent conditional expected present values of the stream of dividends discounted with stochastic intertemporal marginal rates of substitution. These stochastic discount factors vary depending on whether collateral constraints bind or not, and this in turn depends on portfolio choice and equilibrium equity prices. Thus, equilibrium dynamics feature a nonlinear feedback between equity prices, portfolio choice, stochastic discount factors, and collateral constraints. The paper develops a numerical solution method to explore these nonlinear dynamics using a recursive representation of the model's competitive equilibrium.

The quantitative results show that a baseline scenario calibrated to Mexican data and with minimal trading costs can produce reversals in consumption and the current account similar to those observed in actual Sudden Stops. However, low trading costs imply a high price elasticity for the foreign traders' asset demand function, and as a result the fall in asset prices is small. Still, the drop in asset prices is much larger than in the absence of financial frictions.

The model's ability to produce larger (and more realistic) asset price collapses hinges on the size of per-trade asset trading costs. The elasticity of the foreign traders' asset demand function with respect to percent deviations of the fundamentals price from the market price is equal to the inverse of the coefficient that controls the size of these costs. With zero per-trade costs, the foreign trader's demand is infinitely elastic at the fundamentals price, and even in the presence of binding collateral constraints asset prices cannot deviate from their fundamentals level. Sensitivity analysis shows that the model produces Sudden Stops with realistic responses in consumption, the current account and asset prices when per trade costs are set so as to yield a less-than-unitary demand elasticity.

The economy can be inside the high-debt region of the state space in which Sudden Stops occur (i.e., the “Sudden Stop region”) because its initial conditions are in that region (for example, if the economy liberalizes its capital account when its foreign debt is high, or if an unanticipated shock increases its debt burden) or because the endogenous long-run stochastic dynamics of the model lead to some of the states inside that region with positive probability. In the latter case, states in the Sudden Stop region are reached as a result of optimal saving and portfolio choices in the face of particular sequences of productivity shocks. Precautionary saving, however, works to minimize the likelihood that these states are reached in the long run. As a result, long-run business cycle moments for economies with and without financial frictions display minimal differences and the long-run probability of observing binding margin requirements is low, consistent with the fact that Sudden Stops are rare events. In addition, changes in the economic environment that lead to increases in the volatility of asset prices and income, which strengthen incentives for precautionary saving (such as increases in the variability or persistence of productivity shocks) make Sudden Stops larger but reduce their long-run probability.

The transmission mechanism triggering Sudden Stops in this paper differs from others examined in the literature on emerging markets crises based on the closed-economy “financial accelerator” models of Kiyotaki and Moore (1997) and Bernanke et al. (1998). Our model differs in that it introduces elements of equilibrium asset-pricing theory in the presence of aggregate, non-diversifiable risk, “occasionally-binding” collateral constraints and asset trading costs. Most models of Sudden Stops with collateral constraints feature borrowing constraints that are always binding at equilibrium or that emerge as an unanticipated, exogenous shock. In contrast, in the model examined here, collateral constraints become endogenously binding in states of nature in which the economy's debt is sufficiently high and agents formulate optimal plans factoring in the possibility of observing these states. Moreover, in contrast with models that adopt the Bernanke–Gertler setup of costly monitoring, in which the external financing premium is unaffected by aggregate risk and is a smooth function of the net worth/debt ratio, the equilibrium dynamics of our model are influenced by non-insurable risk and the risk premium jumps when collateral constraints bind.

The asset-pricing features of the model are similar to those studied in the closed-economy equilibrium asset-pricing literature by Aiyagari (1993), Lucas (1994), Heaton and Lucas (1996), Krusell and Smith (1997), and Aiyagari and Gertler (1999). These authors examined the asset-pricing implications of borrowing constraints, trading costs and short-selling constraints with the aim to explain facts of U.S. capital markets, particularly the equity premium. The quantitative results were mixed. Yet, financial frictions can still be important for explaining Sudden Stops because empirical regularities like the equity premium relate to moments of the stochastic steady state of a model economy but Sudden Stops are features of equilibrium dynamics when occasionally binding financial frictions bind, even if in the long run these are rare events.

The rest of the paper proceeds as follows. Section 2 presents the model and discusses the financial transmission mechanism. Section 3 reviews key properties of the model's deterministic competitive equilibrium. Section 4 defines the stochastic competitive equilibrium in recursive form and describes the numerical solution method. Section 5 calibrates the model to Mexican data and studies the model's quantitative predictions. Section 6 concludes.

The model can be summarized as a general equilibrium asset-pricing model with financial frictions and two sets of agents: foreign and domestic. Domestic agents are modeled as a representative-agent small open economy subject to non-diversifiable productivity shocks. The residents of this economy are risk averse and trade bonds and equity with the rest of the world. They face a margin requirement that limits their ability to borrow and a short-selling constraint on their equity holdings. Foreign agents are made of two entities: a set of foreign securities firms specialized in trading equity of the small open economy, and the usual global credit market of non-state-contingent, one-period bonds that determines the world's real interest rate via the standard small open economy assumption. Foreign traders face higher costs than domestic agents in trading the small open economy's equity.

Margin requirements and trading costs are modeled following Aiyagari and Gertler (1999). They examined a closed economy in which households face portfolio adjustment costs, securities firms face margin requirements, and income, consumption, and the risk-free real interest rate are exogenous random processes.3 In contrast, in the small open economy examined here, domestic households face margin requirements, foreign traders are subject to trading costs, and consumption and income are endogenous.

There are a large number of identical firms in the small open economy producing a single tradable good using a variable labor input (Lt) and a fixed supply of capital (K). Firms produce this good using a constant-returns-to-scale (CRS) technology exp(ɛt)F(K,Lt) where ɛt is a Markov productivity shock. Firms choose labor demand in order to maximize profits:exp(εt)F(K,Lt)wtLt.

The assumption that the stock of capital is an exogenous constant is adopted for simplicity. This assumption, together with the assumptions about the structure of preferences introduced below, yields equilibrium sequences of labor, wages and dividends that are independent from those of consumption, portfolio choices and asset prices. The drawback is that, by construction, the model's financial frictions cannot alter the manner in which productivity shocks affect output, factor payments and the labor market. Mendoza (2004) studies a model of Sudden Stops in which a collateral constraint similar to the one introduced in this paper affects capital accumulation via Tobin's Q but in a setup without international equity trading.

Labor demand for t = 0, …, ∞ is given by the standard marginal productivity condition:exp(εt)FL(K,Lt)=wtDividend payments for t = 0, …, ∞ are thus given by:dt=exp(εt)FK(K,Lt).

Productivity shocks follow a two-point, symmetric Markov chain. This specification minimizes the size of the exogenous state space E without restricting the variance and first-order autocorrelation of the shocks. The shocks take a high or low value, so E = {ɛH, ɛL}. Symmetry implies that ɛL =  ɛH, and that the long-run probabilities of each state satisfy Π(ɛL) = Π(ɛH) = 1/2. Transition probabilities follow the simple persistence rule (see Backus et al., 1989):πεiεj=(1ϑ)Π(εj)+ϑIεiεj,Iεiεj=1ifi=jand0otherwise, for i,j=L,H.Under these assumptions, the shocks have zero mean, their variance is (ɛH)2, and their autocorrelation coefficient is given by ϑ.

A large number of identical, infinitely lived households inhabit the small open economy. Their preferences are represented by Esptein's (1983) Stationary Cardinal Utility (SCU) function with an endogenous subjective rate of time preference:4U=E[t=0exp{τ=0t1v(cτG(Lτ))}u(ctG(Lt))]With these preferences, the lifetime marginal utility of date  t consumption includes an “impatience effect”, by which a change in ct alters the subjective discount rate applied to the entire future utility stream. The period utility function u is a standard continuously differentiable, concave utility function that satisfies u(·) < 0, u′(·) > 0, u′(0) = ∞, and ln(− u(·)) convex. The time–preference function v must satisfy v(·) > 0, v′(·) > 0, vʺ(·) < 0, and u′(·)exp(v(·)) non-increasing. These conditions are easy to satisfy with standard functional forms such as a constant relative risk aversion (CRRA) period utility function and a logarithmic time–preference function. The argument of the u and v functions is the composite commodity c  G(L) defined by Greenwood et al. (1988), or GHH. G(L) is a concave, continuously differentiable function that measures the disutility of labor. The GHH composite good neutralizes the wealth effect on labor supply by making the marginal rate of substitution between consumption and labor supply depend on the latter only.

Preferences with endogenous impatience play a central role in stochastic small open economy models with incomplete insurance markets because foreign asset holdings diverge to infinity with the standard assumption of an exogenous rate of time preference equal to the world's interest rate. Preferences with a constant rate of impatience support a well-defined stochastic steady state only if the rate of interest is set lower than the rate of time preference arbitrarily, but in this case the mean foreign asset position is largely determined by the ad hoc difference between the two rates (see Arellano and Mendoza, 2003 for details). In models with credit constraints, endogenous impatience is also crucial for supporting stationary equilibria in which these constraints bind (as explained in Section 3).

Households maximize SCU subject to the following period budget constraint:ct=αtKdt+wtLt+qt(αtαt+1)Kbt+1+btRwhere αt and αt+1 are beginning- and end-of-period shares of the domestic capital stock owned by domestic households, bt and bt+1 are holdings of one-period international bonds, qt is the price of equity, and R is the world's gross real interest rate (which is kept constant for simplicity).

In addition to the budget constraint, households face a margin requirement according to which they cannot borrow more than a fraction κ of the value of assets offered as collateral:5bt+1κqtαt+1K,0κ1This is an ex ante collateral constraint that differs in three key respects from ex post collateral constraints (which limit debt not to exceed the discounted one-period-ahead liquidation value of the collateral, as with the Kiyotaki–Moore constraint). First, with a margin clause, custody of the collateral is surrendered to the lender at the time the debt contract is entered. Second, margin calls are automatically triggered by declines in the market value of the collateral, giving lenders the option to liquidate the collateral if borrowers fail to meet margin calls. Third, the borrowing limit depends on current equity prices, rather than on expected prices one period ahead. These properties imply that margin constraints are not affected by some of the strategic issues often raised in connection with other collateral constraints, related to whether countries have efficient institutions to enforce the repossession and liquidation of assets in cases of default and to whether this is even optimal for lenders once they reach a default state. It is also worth noting that margin clauses are widely used in international capital markets and take different forms, ranging from explicit margin clauses imposed by lenders or regulatory agencies to implicit margin clauses, like those implied by the investment banks' use of value-at-risk models to set collateral and capital requirements.6

Households also face a short-selling constraint αt  χ for −  < χ < 1 and t = 1, …, ∞. The case in which χ is positive can be interpreted as a portfolio requirement, or as a constraint stating that only a fraction of the capital stock of the emerging economy is tradable in international equity markets. The constraint αt  χ is needed to ensure that the state space of portfolio holdings is compact and that the margin requirement is not irrelevant. If unlimited short selling of equity were possible, domestic agents could always undo the effect of the margin constraint. The lower bound on equity also serves to support well-behaved equilibria as in other general-equilibrium, incomplete-markets models of asset trading because of the potential for the portfolio αt + bt to become unbounded otherwise.

The first-order conditions of the optimization problem of domestic agents are:UCt(·)=λtG(Lt)=wtqt(λtηtκ)=Et[λt+1(dt+1+qt+1)]+υtλtηt=Et[λt+1R]UCt(·) denotes the lifetime marginal utility of date  t consumption, and λt, ηt, and υt are the nonnegative Lagrange multipliers on the budget constraint, the margin constraint, and the short-selling constraint, respectively. In addition to conditions (8), (9), (10), (11), the first-order conditions include the three constraints and the Kuhn–Tucker conditions associated with each constraint.

The above first-order conditions have straightforward interpretation, with the caveat of the impatience effect on marginal utility. The optimal labor supply condition in (9) shows the effect of the GHH composite good: the marginal disutility of labor is set equal to the real wage without intertemporal effects. Given the realization of ɛt, this condition and the labor demand condition (2) determine equilibrium labor and wages, and hence output and dividends, separately from the rest of the model. Conditions (10), (11) are Euler equations for equity and bonds. Given the definition of equity returns, Rqt + 1 = (dt+1 + qt+1)/qt, these conditions can be combined to derive the following expression for the expected premium on domestic equity:Et[Rqt+1]R=ηt(1κ)υtqtCOVt(λt+1,Rqt+1)Et[λt+1].

If margin and short-selling constraints never bind (i.e., ηt = υt = 0 for all t), this expression yields the standard result for the equity premium of a frictionless model. In contrast, a binding margin requirement at date t (i.e., ηt > 0) increases the equity premium because of the pressure that margin calls exert on households to fire-sell equity, depressing the current equity price. This direct effect of the margin constraint is limited to the fraction (1  κ) of the shadow value ηt because, when the margin constraint binds, the marginal benefit of equity holdings increases by the fraction κ, since more equity holdings help households to relax the borrowing constraint. A binding short-selling constraint (i.e., υt > 0) increases the marginal gain of additional equity holdings and has no effect on the marginal benefit of saving in assets, hence it reduces the equity premium.

In addition to the direct effect, binding margin constraints have an indirect effect. This effect follows from the fact that the conditional covariance between λt+1 and Rqt + 1 in the right-hand-side of (12) is likely to be more negative when margin calls are possible than with a perfect credit market.7 This occurs in turn because the risk of a binding borrowing limit at t + 1 hampers the ability of households to smooth consumption, leading to precautionary saving, increased consumption volatility and a lower covariance between consumption and equity returns (i.e., λt+1 rises while Rqt + 1 falls). The intuition is that equity is a bad hedge against the risk of margin calls because the more negative the covariance between these two variables, the more likely it is that margin calls coincide with low ex-post equity returns. Households will thus demand a larger equity premium to reflect this unhedged risk. Note also that, as in Aiyagari and Gertler (1999), Eq. (12) predicts that excess returns may exist whenever it is possible for a margin call to occur in the future, even if the margin requirement is not binding at present.

To analyze further the effects of margin calls on equity prices, consider the following forward solution derived from Eqs. (10), (11):qt=Et(i=0[j=0i(λt+jEt+j[λt+1+jR]+ηt+j(1κ))]Mt+1+idt+1+i)where Mt+1+i = λt+1+i/λt for i = 0, …, 4, is the stochastic intertemporal marginal rate of substitution between ct+1+i and ct. If the margin requirement never binds, this expression collapses again to a standard asset-pricing formula. If margin calls are possible at any date, the rates at which domestic agents discount future dividends are altered by the direct and indirect effects of margin constraints. The net effect on the price of equity is easier to interpret by solving forward the expression Et[Rqt + 1]  = Et[(dt+1 + qt+1)/qt] to obtain:qt=Et(i=0[j=0i(Et[Rt+1+jq])1]dt+1+i)where the sequence of Et[Rqt + 1 + j] is given by (12). Hence, if the direct and indirect effects of margin calls lead to excess equity returns, a margin requirement that binds at present or is expected to bind in the future implies that some of the expected returns used to discount the future stream of dividends increase, and thus the current price of equity bid by households falls.

It is important to note that at equilibrium the direct and indirect effects of margin calls are amplified by the Fisherian debt-deflation process that results from the interaction between domestic agents and foreign traders in the equity market. A productivity shock triggers an initial margin call. Domestic agents then try to liquidate equity to meet the call, which puts downward pressure on the equilibrium equity price because domestic agents trade with foreign traders who incur trading costs and are thus slow to adjust their portfolios. The resulting fall in equity prices tightens the margin constraint, which leads to further equity sales and further tightening of the margin constraint.

Foreign securities firms maximize the present discounted value of dividends paid to their global shareholders, facing trading costs that are quadratic in the volume of trades (as in Aiyagari and Gertler, 1999) and in a fixed recurrent cost.8 These costs represent the disadvantaged position from which foreign traders operate relative to domestic agents, which may result from informational frictions (i.e., domestic residents may be better informed on economic and political variables relevant for determining the earnings prospects of local firms),9 or from country-specific institutional features or government policies that favor domestic residents. The recurrent cost represents fixed costs for participating in an emerging equity market that foreign traders incur just to be ready to trade, even if they do not actually trade in any given period.

Foreign traders choose αt+1* for t = 0, …, 4, so as to maximize the value of foreign securities firms per unit of capital:D/K=E0[t=0Mt*(αt*(dt+qt)qtαt+1*qt(a2)(αt+1*αt*+θ)2)]θ,a0where M0* = 1 and Mt* for t = 1, …, 4 are the exogenous marginal rates of substitution between date  t consumption and date  0 consumption for the world's representative consumer. For simplicity, these marginal rates of substitution are set to match the world real interest rate, so Mt* = Rt. Trading costs are given by qt(a/2)(αt+1*  αt* + θ)2. The recurrent entry cost is θ and a is an adjustment cost coefficient that determines the price elasticity of the foreign trader's demand for equity, as shown below. Note that θ induces an asymmetry in the manner in which trading costs operate. With θ = 0, the total cost of increasing or reducing equity holdings by a given amount is the same, but with θ > 0 the total cost of reducing equity holdings is higher.

At an interior solution, the first-order conditions for the above optimization problem imply that the foreign traders' demand for equity follows the following partial adjustment rule:(αt+1*αt*)=1a(qtfqt1)θwhere qtf is defined as the “fundamentals” price:qtfEt(i=0Mt+1+i*dt+1+i)Note that this price is not equivalent to the asset price that would prevail in the absence of collateral constraints, because even then equilibrium equity prices would reflect the premium that risk-averse domestic agents would demand for holding equity (whereas the fundamentals price as defined in (17) implies zero equity premia since Mt* = Rt).

According to (16), foreign traders increase their demand for equity by a factor 1/a of the percent deviation of the date  t fundamentals price above the actual price (i.e., 1/a is the elasticity of their demand for equity with respect to the percent deviation of qtf relative to qt). If there were no per-trade trading costs, their demand for equity would be infinitely elastic at qtf and domestic agents could liquidate the shares needed to meet margin calls at an infinitesimal discount below qtf.

An important implication of the incompleteness of asset markets is that, despite asset trading between foreign and domestic agents, the stochastic sequences of their discount factors, Mt+1+i* and Mt+1+i for i = 0, …, ∞, are not equalized. With complete markets, or under perfect foresight, both sequences are equal to the reciprocal of the world interest rate (compounded i periods). Under uncertainty and incomplete markets, however, this is not the case even with an exogenous, risk-free world interest rate. In particular, domestic stochastic discount factors are endogenous and reflect the effects of margin calls.

Given the Markov process of productivity shocks and the initial conditions (b0, α0, α0*), a competitive equilibrium is defined by stochastic sequences of allocations [ct, Lt, bt+1, αt+1, αt+1*]t=0 and prices [wt, dt, qt, Rqt]t=0 such that: (a) domestic firms maximize dividends subject to the CRS technology, taking factor and goods prices as given; (b) households maximize SCU subject to the budget constraint, the margin constraint, and the short-selling constraint, taking as given factor prices, goods prices, the world interest rate and asset prices; (c) foreign securities firms maximize the expected present value of dividends net of trading costs, taking as given asset prices; and (d) the market-clearing conditions for equity, labor, and goods markets hold.

Section snippets

Deterministic stationary equilibrium with and without financial frictions

Under perfect foresight, conditions (12), (13) reduce to the following:Rt+1qR=ηt(1κ)λt+1qt=i=0(j=0i[1+(1κ)ηt+jλt+jηt+j]1Ridt+1+i)As these expressions show, under perfect foresight there is a premium on domestic equity only if the margin requirement binds at date t, and this premium reflects only the direct effect of margin calls.

The above expressions can be used to compare the asset-pricing implications of the margin constraint with those of the Kiyotaki–Moore (KM) collateral

Recursive equilibrium and numerical solution method

The model's competitive equilibrium is solved by reformulating it in recursive form and applying a numerical solution method. The algorithm is designed to deal with four key features of the model: incomplete markets of contingent claims, portfolio choice in a two-agent equilibrium setting, forward-looking asset prices, and occasionally binding margin constraints.

To represent the equilibrium in recursive form, define α and b as the endogenous state variables and ɛ as the exogenous state. Since

Quantitative predictions of the stochastic competitive equilibrium

This section studies the quantitative predictions of the model by examining the results of numerical simulations starting from a baseline case calibrated to Mexican data.

Conclusions

This paper studies the quantitative predictions of a dynamic, stochastic, general equilibrium asset-pricing model with financial frictions to determine if they can rationalize the Sudden Stop phenomenon. The underlying source of uncertainty in the model is a productivity shock of the standard magnitude used in RBC analysis, against which domestic agents cannot hedge because asset markets are incomplete. Two financial frictions are considered. First, domestic residents face a collateral

Acknowledgement

We thank Fernando Alvarez, Cristina Arellano, Leonardo Auernheimer, Guillermo Calvo, Daniele Coen-Pirani, Jonathan Heatcote, Urban Jermann, Fabrizio Perri, Tony Smith, Diego Valderrama, Kirk White and Stan Zin for helpful comments. We also thank seminar participants at the University of Chicago GSB, Georgetown, IDB, Iowa State, Wisconsin, UNC, the 2001 Meeting of the Society for Economic Dynamics and Workshop of the Duke International Economics Group, and the Fall 2003 IFM Program Meeting of

References (40)

  • Auguste, Sebastian, Dominguez, Kathryn M.E., Kamil, Herman, Tesar, Linda L., 2004. Cross-border trading as a mechanism...
  • Cristina Arellano et al.

    Credit frictions and “Sudden Stops” insmall open economies: an equilibrium business cycle framework for emerging markets crises

  • Leonardo Auernheimer et al.

    International Debt and the Price of Domestic Assets

    (2000)
  • David K. Backus et al.

    Risk premiums in the term structure: evidence from artificial economies

    Journal of Monetary Economies

    (1989)
  • Ben Bernanke et al.

    The Financial Accelerator in a Quantitative Business Cycle Framework

    (1998)
  • Guillermo A. Calvo

    Capital flows and capital-market crises: the simple economics of Sudden Stops

    Journal of Applied Economics

    (1998)
  • Guillermo A. Calvo et al.

    Capital-markets crises and economic collapse in emerging markets: an informational-frictions approach

  • Guillermo A. Calvo et al.

    Rational contagion and the globalization of securities markets

    Journal of International Economics

    (2000)
  • Michele Cavallo et al.

    Exchange Rate Overshooting and the Cost of Floating, Mimeo

    (2002)
  • Cespedes, Luis, Chang, Roberto, Velasco, Andres, 2001. Balance sheets and exchange rate policy. Mimeo, Department of...
  • Cited by (89)

    • Does a currency union need a capital market union?

      2022, Journal of International Economics
    • A Fisherian approach to financial crises: Lessons from the Sudden Stops literature

      2020, Review of Economic Dynamics
      Citation Excerpt :

      Moreover, some Fisherian models also include adverse supply-side effects due to declining values of marginal products of inputs in response to price deflation (e.g., Durdu et al., 2009), binding credit limits for working capital (e.g., Bianchi and Mendoza, 2018), and falling investment in response to collapsing equity prices (e.g., Mendoza, 2010). In addition, some models include international spillovers driven by international asset trading and short-selling constraints or mark-to-market capital requirements (e.g., Mendoza and Smith, 2006; Mendoza and Quadrini, 2010). How do results change if we consider a credit constraint independent of market prices instead of the Fisherian constraint?

    View all citing articles on Scopus
    View full text