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A Model of Financial Crises in Open Economies

Author

Listed:
  • Guido Lorenzoni

    (Northwestern)

  • Luigi Bocola

    (Northwestern University)

Abstract

We study a small open economy with flexible exchange rates and a financial sector that faces a potentially binding collateral constraint. Financial crises in the model are self-fulfilling, and they are associated to drops in real economic activity, real exchange rate depreciations, and current account reversals. The presence of dollarized liabilities in the financial sector makes these crises more likely. These currency mismatches arise endogenously because households have a precautionary motive to save in foreign currency when they expect a confidence crisis with sufficiently high probability. In this framework, we analyze the role of a domestic lender of last resort. Precautionary reserve accumulation by the monetary authority facilitates effective lending of last resort, and can lead to a less dollarized financial sector and to a more stable exchange rate.

Suggested Citation

  • Guido Lorenzoni & Luigi Bocola, 2017. "A Model of Financial Crises in Open Economies," 2017 Meeting Papers 385, Society for Economic Dynamics.
    • Handle: RePEc:red:sed017:385
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    Cited by:

    1. Mark Gertler & Nobuhiro Kiyotaki & Andrea Prestipino, 2020. "A Macroeconomic Model with Financial Panics," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 87(1), pages 240-288.
    2. Mark Gertler & Nobuhiro Kiyotaki & Andrea Prestipino, 2020. "Credit Booms, Financial Crises, and Macroprudential Policy," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 37, pages 8-33, August.

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