Financial globalization was off to a rocky start in emerging economies hit by Sudden Stops since the mid 1990s. Foreign reserves grew very rapidly during this period, and hence it is often argued that we live in the era of a New Merchantilism in which large stocks of reserves are a war-chest for defense against Sudden Stops. We conduct a quantitative assessment of this argument using a stochastic intertemporal equilibrium framework with incomplete asset markets in which precautionary saving affects foreign assets via three mechanisms: business cycle volatility, financial globalization, and Sudden Stop risk. In this framework, Sudden Stops are an equilibrium outcome produced by an endogenous credit constraint that triggers Irving Fisher's debt-deflation mechanism. Our results show that financial globalization and Sudden Stop risk are plausible explanations of the observed surge in reserves but business cycle volatility is not. In fact, business cycle volatility has declined in the post-globalization period. These results hold whether we use the formulation of intertemporal preferences of the Bewley-Aiyagari-Hugget class of precautionary savings models or the Uzawa-Epstein setup with endogenous time preference.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
13123.
Length: Date of creation: May 2007 Date of revision: Handle: RePEc:nbr:nberwo:13123
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Find related papers by JEL classification: D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
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Philip R Lane & Jay C Shambaugh, 2007.
"Financial exchange rates and international currency exposures,"
CGFS Papers chapters,
in: Bank for International Settlements (ed.), Research on global financial stability: the use of BIS international financial statistics, volume 29, pages 90-127
Bank for International Settlements.
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