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The impact of financial frictions on a small open economy: when current account borrowing hits a limit

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  • Diego Valderrama

Abstract

The evidence of the last 20 years of recurring output busts and rapid reversals of the current account in emerging markets indicates that domestic agents may not be able to borrow in international capital markets to fully insure themselves against internal and external shocks. This paper models this phenomenon as a form of excess volatility by introducing a financial friction into a stochastic model of a small open economy. The financial friction limits the current account deficit to a fixed fraction of gross domestic product. The paper shows that conditional volatility and asymmetry are significant statistical characteristics of the GDP and current account that reflect the excess volatility and the current account reversals. The economic model can explain the conditional volatility and asymmetry of Mexican GDP and the current account.

Suggested Citation

  • 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.
    • Handle: RePEc:fip:fedfwp:2002-15
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    References listed on IDEAS

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    Cited by:

    1. Bora Durdu & Enrique G. Mendoza, 2004. "Putting the brakes on Sudden Stops: the financial frictions - moral hazard tradeoff of asset price guarantees," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
    2. Nason, James M. & Rogers, John H., 2006. "The present-value model of the current account has been rejected: Round up the usual suspects," Journal of International Economics, Elsevier, vol. 68(1), pages 159-187, January.
    3. Durdu, Ceyhun Bora & Mendoza, Enrique G., 2006. "Are asset price guarantees useful for preventing Sudden Stops?: A quantitative investigation of the globalization hazard-moral hazard tradeoff," Journal of International Economics, Elsevier, vol. 69(1), pages 84-119, June.
    4. Enrique G. Mendoza, 2002. "Why Should Emerging Economies Give up National Currencies: A Case for 'Institutions Substitution'," NBER Working Papers 8950, National Bureau of Economic Research, Inc.
    5. Diego Valderrama, 2003. "Statistical Nonlinearities in the Business Cycle," Computing in Economics and Finance 2003 219, Society for Computational Economics.
    6. Enrique G. Mendoza, 2005. "Sudden Stops in an Equilibrium Business Cycle Model with Credit Constraints: A Fisherian Deflation of Tobin's Q," 2005 Meeting Papers 307, Society for Economic Dynamics.
    7. Valderrama, Diego, 2007. "Statistical nonlinearities in the business cycle: A challenge for the canonical RBC model," Journal of Economic Dynamics and Control, Elsevier, vol. 31(9), pages 2957-2983, September.
    8. Diego Valderrama, 2002. "Nonlinearities in international business cycles," Working Paper Series 2002-23, Federal Reserve Bank of San Francisco.
    9. Adugna Olani, 2016. "Dynamic Capital Inflow Transmission Of Monetary Policy To Emerging Markets," Working Paper 1358, Economics Department, Queen's University.

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