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Sudden stops, financial crises and leverage: a Fisherian deflation of Tobin's Q

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  • Enrique G. Mendoza

Abstract

This paper shows that the quantitative predictions of a DSGE model with an endogenous collateral constraint are consistent with key features of the emerging markets' Sudden Stops. Business cycle dynamics produce periods of expansion during which the ratio of debt to asset values raises enough to trigger the constraint. This sets in motion a deflation of Tobin's Q driven by Irving Fisher's debt-deflation mechanism, which causes a spiraling decline in credit access and in the price and quantity of collateral assets. Output and factor allocations decline because the collateral constraint limits access to working capital financing. This credit constraint induces significant amplification and asymmetry in the responses of macro-aggregates to shocks. Because of precautionary saving, Sudden Stops are low probability events nested within normal cycles in the long run.

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Bibliographic Info

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 960.

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Date of creation: 2008
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Handle: RePEc:fip:fedgif:960

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Keywords: Financial crises ; Econometric models ; Business cycles;

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References

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  1. Mendoza, Enrique G, 1991. "Real Business Cycles in a Small Open Economy," American Economic Review, American Economic Association, vol. 81(4), pages 797-818, September.
  2. Philippe Martin & Hélène Rey, 2005. "Globalization and Emerging Markets: With or Without Crash?," NBER Working Papers 11550, National Bureau of Economic Research, Inc.
  3. Enrique G. Mendoza & Vivian Z. Yue, 2008. "A Solution to the Disconnect between Country Risk and Business Cycle Theories," NBER Working Papers 13861, National Bureau of Economic Research, Inc.
  4. Cook, David & Devereux, Michael B., 2006. "External currency pricing and the East Asian crisis," Journal of International Economics, Elsevier, vol. 69(1), pages 37-63, June.
  5. Roberto Garcia-Saltos & Leonardo Auernheimer, 2000. "International Debt and the Price of Domestic Assets," IMF Working Papers 00/177, International Monetary Fund.
  6. Philip Lane & Gian Maria Milesi-Ferretti, 2001. "THE EXTERNAL WEALTH OF NATIONS: Measures of Foreign Assets and Liabilities For Industrial and Developing Countries," Trinity Economics Papers 20014, Trinity College Dublin, Department of Economics.
  7. Calvo, Guillermo A. & Izquierdo, Alejandro & Loo-Kung, Rudy, 2006. "Relative price volatility under Sudden Stops: The relevance of balance sheet effects," Journal of International Economics, Elsevier, vol. 69(1), pages 231-254, June.
  8. Gopinath, Gita, 2003. "Lending Booms, Sharp Reversals and Real Exchange Rate Dynamics," Scholarly Articles 11988005, Harvard University Department of Economics.
  9. Mendoza, Enrique G. & Smith, Katherine A., 2006. "Quantitative implications of a debt-deflation theory of Sudden Stops and asset prices," Journal of International Economics, Elsevier, vol. 70(1), pages 82-114, September.
  10. David Cook & Woon Gyu Choi, 2002. "Liability Dollarization and the Bank Balance Sheet Channel," IMF Working Papers 02/141, International Monetary Fund.
  11. Ceyhun Bora Durdu & Enrique G. Mendoza & Marco E. Terrones, 2007. "Precautionary Demand for Foreign Assets in Sudden Stop Economies: An Assessment of the New Merchantilism," NBER Working Papers 13123, National Bureau of Economic Research, Inc.
  12. Martin Uribe & Vivian Yue, 2004. "Country spreads and emerging countries: who drives whom?," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  13. Pablo A. Neumeyer & Fabrizio Perri, 2004. "Business cycles in emerging economies: the role of interest rates," Staff Report 335, Federal Reserve Bank of Minneapolis.
  14. Javier García-Cicco & Roberto Pancrazi & Martín Uribe, 2006. "Real Business Cycles in Emerging Countries?," NBER Working Papers 12629, National Bureau of Economic Research, Inc.
  15. Epstein, Larry G., 1983. "Stationary cardinal utility and optimal growth under uncertainty," Journal of Economic Theory, Elsevier, vol. 31(1), pages 133-152, October.
  16. Cook, David & Devereux, Michael B., 2006. "Accounting for the East Asian Crisis: A Quantitative Model of Capital Outflows in Small Open Economies," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(3), pages 721-749, April.
  17. Rodrigo García Verdú, 2005. "Factor Shares From Household Survey Data," Working Papers 2005-05, Banco de México.
  18. Guillermo A. Calvo, 1998. "Capital Flows and Capital-Market Crises: The Simple Economics of Sudden Stops," Journal of Applied Economics, Universidad del CEMA, vol. 0, pages 35-54, November.
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Cited by:
  1. Philip L. Brock, 2009. "Collateral Constraints and Macroeconomic Adjustment in an Open Economy," Working Papers UWEC-2009-03, University of Washington, Department of Economics.
  2. Klaus Weyerstrass & Daniela Grozea-Helmenstein, 2013. "Euro Area Scenarios and their Economic Consequences for Slovenia and Serbia," Managing Global Transitions, University of Primorska, Faculty of Management Koper, vol. 11(4 (Winter), pages 323-351.
  3. Marco Terrones & M. Ayhan Kose & Stijn Claessens, 2008. "What Happens During Recessions, Crunches, and Busts?," IMF Working Papers 08/274, International Monetary Fund.
  4. Zheng Liu & Pengfei Wang & Tao Zha, 2010. "Do credit constraints amplify macroeconomic fluctuations?," Working Paper 2010-01, Federal Reserve Bank of Atlanta.
  5. Argandoña, Antonio, 2012. "Three ethical dimensions of the financial crisis," IESE Research Papers D/944, IESE Business School.
  6. Enrique G. Mendoza & Vincenzo Quadrini, 2009. "Financial Globalization, Financial Crises and Contagion," NBER Working Papers 15432, National Bureau of Economic Research, Inc.
  7. Hevia, Constantino, 2009. "Emerging market fluctuations : what makes the difference ?," Policy Research Working Paper Series 4897, The World Bank.

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