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Can Miracles Lead to Crises? The Role of Optimism in Emerging Markets Crises

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Emine Boz

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Abstract

Emerging market financial crises are abrupt and dramatic, usually occurring after a period of high output growth, massive capital flows, and a boom in asset markets. This paper develops an equilibrium asset-pricing model with informational frictions in which vulnerability and the crisis itself are consequences of the investor optimism in the period preceding the crisis. The model features two sets of investors, domestic and foreign. Both sets of investors learn from noisy signals, which contain information relevant for asset returns and formulate expectations, or "beliefs," about the state of productivity. We show that, if preceded by a sequence of positive signals, a small, negative noise shock can trigger a sharp downward adjustment in investors' beliefs, asset prices, and consumption. The magnitude of this downward adjustment and sensitivity to negative signals increase with the level of optimism attained prior to the negative signal.

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Paper provided by International Monetary Fund in its series IMF Working Papers with number 07/223.

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Length: 34 pages
Date of creation: 20 Sep 2007
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Handle: RePEc:imf:imfwpa:07/223

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Keywords: Working Paper ; Financial crisis ; Emerging markets ; Investment ; Foreign investment ; Consumption ; Asset prices ; Economic models ;

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  2. Heaton, John & Lucas, Deborah J, 1996. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 443-87, June. [Downloadable!] (restricted)
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  3. Judd, Kenneth L., 1992. "Projection methods for solving aggregate growth models," Journal of Economic Theory, Elsevier, vol. 58(2), pages 410-452, December. [Downloadable!] (restricted)
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  4. Gourinchas, Pierre-Olivier & Tornell, Aaron, 2003. "Exchange Rate Dynamics, Learning and Misperception," CEPR Discussion Papers 3725, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  5. Paasche, Bernhard, 2001. "Credit constraints and international financial crises," Journal of Monetary Economics, Elsevier, vol. 48(3), pages 623-650, December. [Downloadable!] (restricted)
  6. Enrique G. Mendoza & Katherine A. Smith, 2004. "Quantitative Implication of A Debt-Deflation Theory of Sudden Stops and Asset Prices," NBER Working Papers 10940, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  7. 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. [Downloadable!]
  8. Domowitz, Ian & Glen, Jack & Madhavan, Ananth, 2001. "Liquidity, Volatility and Equity Trading Costs across Countries and over Time," International Finance, Blackwell Publishing, vol. 4(2), pages 221-55, Summer. [Downloadable!] (restricted)
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  9. Caballero, Ricardo J. & Krishnamurthy, Arvind, 2001. "International and domestic collateral constraints in a model of emerging market crises," Journal of Monetary Economics, Elsevier, vol. 48(3), pages 513-548, December. [Downloadable!] (restricted)
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  10. Rui Albuquerque & Gregory H. Bauer & Martin Schneider, 2004. "International equity flows and returns: A quantitative equilibrium approach," Working Paper Series 310, European Central Bank. [Downloadable!]
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  11. Calvo, Guillermo A. & Mendoza, Enrique G., 2000. "Rational contagion and the globalization of securities markets," Journal of International Economics, Elsevier, vol. 51(1), pages 79-113, June. [Downloadable!] (restricted)
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  12. Moore, Bartholomew & Schaller, Huntley, 2002. "Persistent and Transitory Shocks, Learning, and Investment Dynamics," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 34(3), pages 650-77, August.
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  13. S. Rao Aiyagari & Mark Gertler, 1999. ""Overreaction" of Asset Prices in General Equilibrium," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 2(1), pages 3-35, January. [Downloadable!] (restricted)
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  1. Emine Boz & Christian Daude & Ceyhun Bora Durdu, 2008. "Emerging market business cycles revisited: learning about the trend," International Finance Discussion Papers 927, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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