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Lessons From the Debt-Deflation Theory of Sudden Stops

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  • Enrique G. Mendoza

Abstract

This paper reports results for a class of dynamic, stochastic general equilibrium models with credit constraints that can account for some of the empirical regularities of the Sudden Stop phenomenon of recent emerging markets crises. In these models, credit constraints set in motion Irving Fisher's debt-deflation mechanism and they bind as an endogenous equilibrium outcome when agents are highly indebted. The quantitative predictions of these models yield three key lessons: (1) Sudden Stops can occur as an endogenous response to typical realizations of adverse shocks to fundamentals, in environments in which agents plan their actions taking credit constraints and expectations of Sudden Stops into account. (2) Credit constraints cause output declines during Sudden Stops when collateral constraints limit debt to a fraction of the market value of capital, when there are limits on access to working capital, or when debt-deflation lowers the value of the marginal product of factors of production. (3) The debt-deflation mechanism has significant quantitative effects in terms of the amplification, asymmetry and persistence of the responses of macroeconomic aggregates to standard shocks, and in the occurrence of Sudden Stops as infrequent events nested within regular business cycles. Precautionary saving rules out the largest Sudden Stops from the stochastic stationary state, but Sudden Stops remain a positive-probability event in the long run.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11966.

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Date of creation: Jan 2006
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Publication status: published as Mendoza, Enrique G. "Lessons From The Debt-Deflation Theory Of Sudden Stops," American Economic Review, 2006, v96(2,May), 411-416.
Handle: RePEc:nbr:nberwo:11966

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  1. Cristina Arellano & Enrique Mendoza, 2002. "Credit Frictions and 'Sudden Stops' in Small Open Economies: An Equilibrium Business Cycle Framework for Emerging Markets Crises," Research Department Publications, Inter-American Development Bank, Research Department 4307, Inter-American Development Bank, Research Department.
  2. Philippe Martin & Hélène Rey, 2006. "Globalization and Emerging Markets: With or Without Crash?," Sciences Po publications, Sciences Po info:hdl:2441/9261, Sciences Po.
  3. Pablo Andres Neumeyer & Fabrizio Perri, 1999. "Business Cycles in Emerging Economies: the role of interest rates," Department of Economics Working Papers, Universidad Torcuato Di Tella 014, Universidad Torcuato Di Tella.
  4. Enrique G. Mendoza, 2005. "Sudden Stops in an Equilibrium Business Cycle Model with Credit Constraints: A Fisherian Deflation of Tobin's Q," 2005 Meeting Papers, Society for Economic Dynamics 307, Society for Economic Dynamics.
  5. Ceyhun Bora Durdu & Enrique G. Mendoza, 2005. "Are Asset Price Guarantees Useful for Preventing Sudden Stops?: A Quantitative Investigation of the Globalization Hazard-Moral Hazard Tradeoff," NBER Working Papers 11178, National Bureau of Economic Research, Inc.
  6. Cook, David & Devereux, Michael B., 2006. "External currency pricing and the East Asian crisis," Journal of International Economics, Elsevier, Elsevier, vol. 69(1), pages 37-63, June.
  7. Gopinath, Gita, 2004. "Lending booms, sharp reversals and real exchange rate dynamics," Journal of International Economics, Elsevier, Elsevier, vol. 62(1), pages 1-23, January.
  8. Oviedo, P. Marcelo, 2005. "World Interest Rate, Business Cycles, and Financial Intermediation in Small Open Economies," Staff General Research Papers, Iowa State University, Department of Economics 12360, Iowa State University, Department of Economics.
  9. Enrique G. Mendoza, 2001. "Credit, Prices, and Crashes: Business Cycles with a Sudden Stop," NBER Working Papers 8338, National Bureau of Economic Research, Inc.
  10. Emine Boz, 2005. "Do Miracles Lead to Crises?: An Informational Frictions Explanation to Emerging Market Financial Crises," 2005 Meeting Papers, Society for Economic Dynamics 496, Society for Economic Dynamics.
  11. Enrique G. Mendoza, 2006. "Real Exchange Rate Volatility and the Price of Nontradables in Sudden-Stop-Prone Economies," IMF Working Papers, International Monetary Fund 06/88, International Monetary Fund.
  12. 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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  14. V. V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2005. "Sudden Stops and Output Drops," Levine's Bibliography 122247000000000880, UCLA Department of Economics.
  15. Ricardo Caballero & Stavros Panageas, 2005. "A Quantitative Model of Sudden Stops and External Liquidity Management," NBER Working Papers 11293, National Bureau of Economic Research, Inc.
  16. Finn, Mary G., 1995. "Variance properties of Solow's productivity residual and their cyclical implications," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 19(5-7), pages 1249-1281.
  17. Mendoza, Enrique G, 1991. "Real Business Cycles in a Small Open Economy," American Economic Review, American Economic Association, American Economic Association, vol. 81(4), pages 797-818, September.
  18. S. Rao Aiyagari & Mark Gertler, 1999. ""Overreaction" of Asset Prices in General Equilibrium," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 2(1), pages 3-35, January.
  19. Narayana R. Kocherlakota, 2000. "Creating business cycles through credit constraints," Quarterly Review, Federal Reserve Bank of Minneapolis, Federal Reserve Bank of Minneapolis, issue Sum, pages 2-10.
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Cited by:
  1. Mendicino, Caterina, 2012. "On the amplification role of collateral constraints," Economics Letters, Elsevier, Elsevier, vol. 117(2), pages 429-435.
  2. Ronald U. Mendoza, 2007. "A Compendium of Policy Instruments to Enhance Financial Stability and Debt Management in Emerging Market Economies," Working Papers, United Nations, Department of Economics and Social Affairs 48, United Nations, Department of Economics and Social Affairs.
  3. Marco E. Terrones & Enrique G. Mendoza & Ceyhun Bora Durdu, 2008. "Precautionary Demand for Foreign Assets in Sudden Stop Economies: An Assessment of the New Mercantilism," 2008 Meeting Papers 56, Society for Economic Dynamics.
  4. Aysun, Uluc & Honig, Adam, 2011. "Bankruptcy costs, liability dollarization, and vulnerability to sudden stops," Journal of Development Economics, Elsevier, Elsevier, vol. 95(2), pages 201-211, July.
  5. Galina Hale & Assaf Razin & Hui Tong, 2008. "Credit Crunch, Creditor Protection, and Asset Prices," Working Papers, Hong Kong Institute for Monetary Research 162008, Hong Kong Institute for Monetary Research.
  6. Levan Efremidze & Akinori Tomohara, 2011. "Have the Implications of Twin Deficits Changed?: Sudden Stops over Decades," International Advances in Economic Research, Springer, Springer, vol. 17(1), pages 66-76, February.
  7. Thierry Tressel & Thierry Verdier, 2007. "Financial Globalization and the Governance of Domestic Financial Intermediaries," IMF Working Papers, International Monetary Fund 07/47, International Monetary Fund.
  8. Almira Buzaushina & Michael Brei, 2009. "Matching International Financial Shocks in Emerging Markets," Bonn Econ Discussion Papers, University of Bonn, Germany bgse2_2009, University of Bonn, Germany.
  9. Aliya Algozhina, 2012. "Monetary and Fiscal Policy Interactions in an Emerging Open Economy: A Non-Ricardian DSGE Approach," CERGE-EI Working Papers, The Center for Economic Research and Graduate Education - Economic Institute, Prague wp476, The Center for Economic Research and Graduate Education - Economic Institute, Prague.
  10. Hale, Galina B & Razin, Assaf & Tong, Hui, 2008. "Creditor Protection, Contagion, and Stock Market Price Volatility," CEPR Discussion Papers, C.E.P.R. Discussion Papers 6658, C.E.P.R. Discussion Papers.
  11. Joyce, Joseph P. & Nabar, Malhar, 2009. "Sudden stops, banking crises and investment collapses in emerging markets," Journal of Development Economics, Elsevier, Elsevier, vol. 90(2), pages 314-322, November.
  12. Jaromir Benes & Andrew Berg & Rafael Portillo & Mai Dao & Alfredo Baldini, 2012. "Monetary Policy in Low Income Countries in the Face of the Global Crisis," IMF Working Papers, International Monetary Fund 12/94, International Monetary Fund.
  13. Hale, Galina B & Razin, Assaf & Tong, Hui, 2007. "Creditor Protection and Stock Price Volatility," CEPR Discussion Papers, C.E.P.R. Discussion Papers 6540, C.E.P.R. Discussion Papers.

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