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Can Miracles Lead to Crises? An Informational Frictions Explanation of Emerging Markets Crises

  • Emine Boz

    ()

    (Economics University of Maryland)

Emerging market financial crises are abrupt and dramatic, usually occurring after a period of high output growth, massive capital flows, and a boom in asset markets. This paper develops an equilibrium asset pricing model with informational frictions in which vulnerability and the crisis itself are consequences of the investor optimism in the period preceding the crisis. The model features two sets of investors, domestic and foreign. Both sets of investors are imperfectly informed about the true state of the emerging economy. Investors learn from noisy signals which contain information relevant for asset returns and formulate expectations, or ``beliefs'', about the state of productivity. Numerical analysis shows that, if preceded by a sequence of positive signals, a small, negative noise shock can trigger a sharp downward adjustment in investors' beliefs, asset prices, and consumption. The magnitude of this downward adjustment and sensitivity to negative signals increase with the level of optimism attained prior to the negative signal. Moreover, with the introduction of informational frictions, asset prices display persistent effects in response to transitory shocks, and the volatility of consumption increases

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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2006 with number 19.

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Date of creation: 04 Jul 2006
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Handle: RePEc:sce:scecfa:19
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