Exchange rate dynamics, balance sheet effects, and capital flows. A Minskyan model of emerging market boom-bust cycles

The paper provides a Minskyan open economy model of endogenous boom-bust cycles in emerging market economies, which explains the empirically observed procyclicality of exchange rates and the countercyclicality of the trade balance. It highlights the interaction of flexible exchange rate dynamics with balance sheets. Currency appreciation improves the net worth of firms with foreign currency debt, giving a boost to investment. Throughout the boom phase, the trade balance worsens. Pressures on the domestic exchange rate mount until the currency depreciates. Contractionary balance sheet effects then set in as domestic firms face a drop in their net worth. If capital inflows are driven by exogenous risk appetite, fluctuations can assume the form of shock-independent endogenous cycles. An increase in risk appetite raises the volatility of the cycle. Financial account regulation can reduce macroeconomic volatility, but the larger the risk appetite, the more financial account regulation is required to achieve this.