Balance of Payments Crises and Capital Flows: The Role of Liquidity
A model of external crises is developed focusing on the interaction between liquidity creation by financial intermediaries and foreign exchange collapses. The intermediaries' role of transforming maturities is shown to result in larger movements of capital and a higher probability of crises. This resembles the observed cycle in capital flows: large inflows, crises and abrupt outflows. The model highlights how adverse productivity and international interest rate shocks can be magnified by the behavior of individual foreign investors linked together through their deposits in the intermediaries. An eventual collapse of the exchange rate can link investors' behavior even further.
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