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Endogenous Borrowing Constraints and Consumption Volatility in a Small Open Economy

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  • Carlos de Resende

Abstract

Consumption volatility relative to output volatility is consistently higher in emerging economies than in developed economies. One natural explanation is that emerging economies are more likely to face borrowing constraints and, as a consequence, find it more difficult to use international capital markets to smooth consumption. The author investigates how much this mechanism alone can account for the relative consumption volatility differential between emerging and developed economies. His theoretical approach relies on a standard dynamic general-equilibrium model of a small open endowment economy that is subject to an endogenous borrowing constraint. The borrowing constraint makes the small economy exactly indifferent between two options: (i) repaying its external debt, or (ii) defaulting and having to live in financial autarky in the future. The model for the constrained economy is calibrated to match Brazilian data during the period 1980-2001. The author's findings suggest that the model is capable of accounting for more than half of the observed relative consumption volatility differential.

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Bibliographic Info

Paper provided by Bank of Canada in its series Working Papers with number 06-37.

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Length: 41 pages
Date of creation: 2006
Date of revision:
Handle: RePEc:bca:bocawp:06-37

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Keywords: International topics;

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References

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  1. Cole, Harold L & Dow, James & English, William B, 1995. "Default, Settlement, and Signalling: Lending Resumption in a Reputational Model of Sovereign Debt," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 36(2), pages 365-85, May.
  2. Reinhart, Carmen & Calvo, Guillermo & Leiderman, Leonardo, 1992. "Capital Inflows and Real Exchange Rate Appreciation in Latin America," MPRA Paper 13843, University Library of Munich, Germany.
  3. Jeremy I. Bulow & Kenneth Rogoff, 1988. "Sovereign Debt: Is To Forgive To Forget?," NBER Working Papers 2623, National Bureau of Economic Research, Inc.
  4. Reinhart, Carmen & Calvo, Guillermo, 2000. "When Capital Inflows Come to a Sudden Stop: Consequences and Policy Options," MPRA Paper 6982, University Library of Munich, Germany.
  5. S. Rao Aiyagari & Mark Gertler, 1990. "Asset Returns with Transactions Cost and Uninsured Risk: A Stage III Exercise," NBER Working Papers 3481, National Bureau of Economic Research, Inc.
  6. Herschel I. Grossman & T. Han, 1997. "Sovereign Debt and Consumption Smoothing," Working Papers 97-6, Brown University, Department of Economics.
  7. Greenwood, Jeremy & Hercowitz, Zvi & Huffman, Gregory W, 1988. "Investment, Capacity Utilization, and the Real Business Cycle," American Economic Review, American Economic Association, vol. 78(3), pages 402-17, June.
  8. Calvo, Guillermo A. & Vegh, Carlos A., 1999. "Inflation stabilization and bop crises in developing countries," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 24, pages 1531-1614 Elsevier.
  9. Mark Aguiar & Gita Gopinath, 2004. "Defaultable debt, interest rates, and the current account," Working Papers 04-5, Federal Reserve Bank of Boston.
  10. Cole, Harold L. & Kehoe, Patrick J., 1995. "The role of institutions in reputation models of sovereign debt," Journal of Monetary Economics, Elsevier, vol. 35(1), pages 45-64, February.
  11. Cristina Arellano, 2005. "Default Risk, the Real Exchange Rate and Income Fluctuations in Emerging Economies," 2005 Meeting Papers 516, Society for Economic Dynamics.
  12. S Rao Aiyagari & Mark Gertler, 1997. "Asset Returns with transaction costs and uninsured individual risk," Levine's Working Paper Archive 648, David K. Levine.
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Cited by:
  1. International Monetary Fund, 2011. "Business Cycles in Emerging Markets," IMF Working Papers 11/133, International Monetary Fund.
  2. Álvarez-Parra, Fernando & Brandao-Marques, Luis & Toledo, Manuel, 2013. "Durable goods, financial frictions, and business cycles in emerging economies," Journal of Monetary Economics, Elsevier, vol. 60(6), pages 720-736.
  3. Carlos de Resende, 2007. "IMF-Supported Adjustment Programs: Welfare Implications and the Catalytic Effect," Working Papers 07-22, Bank of Canada.
  4. Manuel Toledo & Luis B. Marques & Fernando A. Alvarez, 2009. "Excess Volatility of Consumption in Developed and Emerging Markets: The Role of Durable Goods," 2009 Meeting Papers 142, Society for Economic Dynamics.

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