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External Debt in Emerging Economies: A Macrodynamical Model of Financial Fragility

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  • Eleonora Cavallaro
  • Marcella Mulino

Abstract

Following both the balance-sheet approach to currency crises and the financial fragility literature, the paper presents an open economy macrodynamical monetary growth model with the aim of giving an endogenous characterisation to the process that, over time, leads an emerging economy to accumulate dangerously high levels of debt and to be vulnerable to macroeconomic instability. The model explores the nonlinear real and financial interaction at work, with the endogenously generated liquidity feeding back dynamically to firms’ investment, the level of output, the interest rate and the expected rate of return. The paper shows that the system may display instability if lenders and borrowers are not too concerned with firms’ degree of leverage, profitability expectations do not take adequately into account firms’ financial structure, and destabilising feedback mechanisms dominate, which go from debt accumulation and profitability expectations onto the rate of profit and the interest rate. As a result, the economy may incur in excessive foreign borrowing. The consequent worsening in firms’ balance sheets may turn into financial fragility, and over time bring about a fall in external lending. A prolonged recession may thus follow, possibly calling into question the currency arrangements; hence, a financial crisis may turn into a currency crisis.
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Suggested Citation

  • Eleonora Cavallaro & Marcella Mulino, 2004. "External Debt in Emerging Economies: A Macrodynamical Model of Financial Fragility," STUDI ECONOMICI, FrancoAngeli Editore, vol. 2004(84).
  • Handle: RePEc:fan:steste:v:html10.3280/ste2004-084001
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    References listed on IDEAS

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    1. Barry Eichengreen & Ricardo Hausmann & Ugo Panizza, 2007. "Currency Mismatches, Debt Intolerance, and the Original Sin: Why They Are Not the Same and Why It Matters," NBER Chapters,in: Capital Controls and Capital Flows in Emerging Economies: Policies, Practices and Consequences, pages 121-170 National Bureau of Economic Research, Inc.
    2. Roberto Chang & Andres Velasco, 1998. "Financial crises in emerging markets: a canonical model," FRB Atlanta Working Paper 98-10, Federal Reserve Bank of Atlanta.
    3. Carmen M. Reinhart & Kenneth S. Rogoff & Miguel A. Savastano, 2003. "Debt Intolerance," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(1), pages 1-74.
    4. Mark Gertler & Simon Gilchrist & Fabio M. Natalucci, 2007. "External Constraints on Monetary Policy and the Financial Accelerator," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(2-3), pages 295-330, March.
    5. Luis Felipe Céspedes & Roberto Chang & Andrés Velasco, 2004. "Balance Sheets and Exchange Rate Policy," American Economic Review, American Economic Association, vol. 94(4), pages 1183-1193, September.
    6. Roberto Chang & Andres Velasco, 1998. "Financial Crises in Emerging Markets," NBER Working Papers 6606, National Bureau of Economic Research, Inc.
    7. Mulino, Marcella, 2002. "Currency boards, credibility and crises," Economic Systems, Elsevier, vol. 26(4), pages 381-386, December.
    8. Gatti, D. Delli & Gallegati, M. & Gardini, L., 1993. "Investment confidence, corporate debt and income fluctuations," Journal of Economic Behavior & Organization, Elsevier, vol. 22(2), pages 161-187, October.
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    More about this item

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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