IDEAS home Printed from
MyIDEAS: Login to save this article or follow this journal

Putting the brakes on Sudden Stops: the financial frictions - moral hazard tradeoff of asset price guarantees

  • Enrique G. Mendoza
  • Ceyhun Bora Durdu

The hypothesis that Sudden Stops to capital inflows in emerging economies may originate in frictions inherent to global capital markets, such as collateral constraints and trading costs, suggests that Sudden Stops could be prevented by an international organization that offers exante price guarantees on the emerging-markets asset class. Providing these guarantees is a risky endeavor, however, because they introduce a moral-hazard-like incentive similar to those that are viewed as another culprit behind emerging markets crises. This paper studies this financial frictions-moral hazard tradeoff using an equilibrium asset-pricing model in which margin constraints, trading costs, and ex-ante price guarantees interact in the determination of asset prices and macroeconomic dynamics. In the absence of price guarantees, margin calls and trading costs create distortions in asset markets that produce Sudden Stops driven by occasionally binding credit constraints and Irving Fisher’s debt-deflation mechanism, as in the model proposed by Mendoza and Smith (2003). Price guarantees contain the asset deflation by creating another distortion that props up the foreign investors’ demand for emerging markets assets. Quantitative simulation analysis shows the strong interaction of these two distortions in determining asset prices and the dynamics of consumption and the current account. Price guarantees are shown to be effective at containing Sudden Stops but at the cost of introducing potentially large distortions leading to ‘overvaluation’ of emerging markets assets.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL:
Download Restriction: no

Article provided by Federal Reserve Bank of San Francisco in its journal Proceedings.

Volume (Year): (2004)
Issue (Month): Jun ()

in new window

Handle: RePEc:fip:fedfpr:y:2004:i:jun:x:10
Contact details of provider: Postal: P.O. Box 7702, San Francisco, CA 94120-7702
Phone: (415) 974-2000
Fax: (415) 974-3333
Web page:

More information through EDIRC

Order Information: Email:

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

as in new window
  1. Jonathan Eaton & Mark Gersovitz, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Oxford University Press, vol. 48(2), pages 289-309.
  2. Frankel, Jeffrey A. & Rose, Andrew K., 1996. "Currency crashes in emerging markets: An empirical treatment," Journal of International Economics, Elsevier, vol. 41(3-4), pages 351-366, November.
  3. Andrew K. Rose, 2002. "One Reason Countries Pay Their Debts: Renegotiation and International Trade," Working Papers 042002, Hong Kong Institute for Monetary Research.
  4. Mark Aguiar & Gita Gopinath, 2004. "Emerging Market Business Cycles: The Cycle is the Trend," NBER Working Papers 10734, National Bureau of Economic Research, Inc.
  5. repec:att:wimass:8813 is not listed on IDEAS
  6. Timothy J. Kehoe & David K. Levine, 1992. "Debt constrained asset markets," Working Papers 445, Federal Reserve Bank of Minneapolis.
  7. Neumeyer, Pablo A. & Perri, Fabrizio, 2005. "Business cycles in emerging economies: the role of interest rates," Journal of Monetary Economics, Elsevier, vol. 52(2), pages 345-380, March.
  8. Roberto Garcia-Saltos & Leonardo Auernheimer, 2000. "International Debt and the Price of Domestic Assets," IMF Working Papers 00/177, International Monetary Fund.
  9. Atkeson, Andrew, 1991. "International Lending with Moral Hazard and Risk of Repudiation," Econometrica, Econometric Society, vol. 59(4), pages 1069-89, July.
  10. Calvo, Guillermo A. & Mendoza, Enrique G., 1996. "Mexico's balance-of-payments crisis: a chronicle of a death foretold," Journal of International Economics, Elsevier, vol. 41(3-4), pages 235-264, November.
  11. 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 4307, Inter-American Development Bank, Research Department.
  12. Jeremy I. Bulow & Kenneth Rogoff, 1988. "Sovereign Debt: Is To Forgive To Forget?," NBER Working Papers 2623, National Bureau of Economic Research, Inc.
  13. Gian Maria Milesi Ferretti & Assaf Razin, 2000. "Current Account Reversals and Currency Crises: Empirical Regularities," NBER Chapters, in: Currency Crises, pages 285-323 National Bureau of Economic Research, Inc.
  14. Patrick J. Kehoe & Fabrizio Perri, 2000. "International Business Cycles with Endogenous Incomplete Markets," NBER Working Papers 7870, National Bureau of Economic Research, Inc.
  15. Enrique G. Mendoza, 1991. "Capital Controls and the Gains from Trade in a Business Cycle Model of a Small Open Economy," IMF Staff Papers, Palgrave Macmillan, vol. 38(3), pages 480-505, September.
  16. Aiyagari, S.R. & Gertler, M., 1998. ""Overreaction" of Asset Prices in General Equilibrium," Working Papers 98-25, C.V. Starr Center for Applied Economics, New York University.
  17. Greenwood, Jeremy & Hercowitz, Zvi & Huffman, Gregory W, 1988. "Investment, Capacity Utilization, and the Real Business Cycle," American Economic Review, American Economic Association, vol. 78(3), pages 402-17, June.
  18. 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.
  19. Pierre-Olivier Gourinchas & Olivier Jeanne, 2004. "The Elusive Gains from International Financial Integration," IMF Working Papers 04/74, International Monetary Fund.
  20. Aiyagari, S.R. & Gertler, M., 1998. ""Overreaction" of Asset Prices in General Equilibrium," Working Papers 98-25, C.V. Starr Center for Applied Economics, New York University.
  21. Satyajit Chatterjee & Dean Corbae & Makoto Nakajima & José-Víctor Ríos-Rull, 2007. "A Quantitative Theory of Unsecured Consumer Credit with Risk of Default," Econometrica, Econometric Society, vol. 75(6), pages 1525-1589, November.
  23. 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.
  24. Lerrick, Adam & Meltzer, Allan H., 2003. "Blueprint for an international lender of last resort," Journal of Monetary Economics, Elsevier, vol. 50(1), pages 289-303, January.
  25. Diego Valderrama, 2002. "The impact of financial frictions on a small open economy: when current account borrowing hits a limit," Working Paper Series 2002-15, Federal Reserve Bank of San Francisco.
  26. Rudiger Dornbusch & Sebastian Edwards, 1989. "Macroeconomic Populism in Latin America," NBER Working Papers 2986, National Bureau of Economic Research, Inc.
  27. 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.
  28. Enrique G. Mendoza & Guillermo A. Calvo, 2000. "Capital-Markets Crises and Economic Collapse in Emerging Markets: An Informational-Frictions Approach," American Economic Review, American Economic Association, vol. 90(2), pages 59-64, May.
  29. Timothy J. Kehoe & David K. Levine, 1993. "Debt-Constrained Asset Markets," Review of Economic Studies, Oxford University Press, vol. 60(4), pages 865-888.
  30. Enrique G. Mendoza & Katherine A. Smith, 2002. "Margin Calls, Trading Costs, and Asset Prices in Emerging Markets: The Finanical Mechanics of the 'Sudden Stop' Phenomenon," NBER Working Papers 9286, National Bureau of Economic Research, Inc.
  31. repec:fth:starer:9825 is not listed on IDEAS
  32. Paasche, Bernhard, 2001. "Credit constraints and international financial crises," Journal of Monetary Economics, Elsevier, vol. 48(3), pages 623-650, December.
  33. Epstein, Larry G., 1983. "Stationary cardinal utility and optimal growth under uncertainty," Journal of Economic Theory, Elsevier, vol. 31(1), pages 133-152, October.
  34. Gelos, R. Gaston & Sahay, Ratna & Sandleris, Guido, 2011. "Sovereign borrowing by developing countries: What determines market access?," Journal of International Economics, Elsevier, vol. 83(2), pages 243-254, March.
  35. Tauchen, George & Hussey, Robert, 1991. "Quadrature-Based Methods for Obtaining Approximate Solutions to Nonlinear Asset Pricing Models," Econometrica, Econometric Society, vol. 59(2), pages 371-96, March.
  36. Sebastian Edwards & Jeffrey A. Frankel, 2002. "Preventing Currency Crises in Emerging Markets," NBER Books, National Bureau of Economic Research, Inc, number edwa02-2, December.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:fip:fedfpr:y:2004:i:jun:x:10. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Noah Pollaczek)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.