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The Role of Expectations in Sudden Stops

  • Karel Mertens

This paper presents a flexible-price small open economy model with a “peso problem” in productivity states. Agents rationally adjust their beliefs about future productivity growth after the arrival of news. A downward revision of expectations triggers a Sudden Stop, together with large declines in GDP, employment, consumption and investment. There need not be any actual change in productivity growth to generate large fluctuations. Quantitatively, the model goes a long way in matching the 1998 Korean Crisis and subsequent swift recovery.

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Paper provided by European University Institute in its series Economics Working Papers with number ECO2007/16.

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Date of creation: 2007
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Handle: RePEc:eui:euiwps:eco2007/16
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