Credit constraints that link a private agent’s debt to market-determined prices embody a credit externality that drives a wedge between competitive and constrained socially optimal equilibria, inducing private agents to “overborrow. ” The externality arises because agents fail to internalize the price effects of additional borrowing when the credit constraint binds. We quantify the effects of this inefficiency in a two-sector DSGE model of a small open economy calibrated to emerging markets. The credit externality increases the probability of financial crises by a factor of 7 and causes the maximum drop in consumption to increase by 10 percentage points.

The “Sudden Stop ” phenomenon of the recurrent emerging markets crises of the last ten years is one of the key questions facing International Macroeconomics. Sudden Stops are defined by unusually large recessions marked by: sharp, abrupt current account reversals, large contractions in output and absorption, and collapses in goods and asset prices. In Mexico’s 1995 Sudden Stop, for example, the current account shifted by nearly 9 percentage points of GDP, and GDP, consumption and investment fell by magnitudes that exceeded their business cycle standard deviations by about a factor of 3. Only the Great Depression shows a recession with comparable magnitudes in the country’s economic history. The dominant paradigms of the early 1990s, International Real Business Cycle Theory (IRBC) and the New Open Economy Macroeconomics, were unable to explain Sudden Stops because they assume a perfect global credit market that allows households to smooth consumption, and firms to finance production and investment efficiently. For example, small open economy (SOE) models in the IRBC tradition predict that, when a negative, transitory productivity shock hits, households borrow to smooth consumption, firms keep investment and production plans unaltered, and the current account falls slightly. If the shock has some persistence, households borrow less and adjust consumption more, and firms cut investment and production, resulting in regular, countercyclical current account fluctuations. Indeed, SOE-IRBC models proved quite good at mimicking the business cycles of industrial economies. Sudden Stops are strikingly different. At the time that output experiences Great-Depression-size declines, the current account takes an abrupt jump up and domestic absorption plummets. Just when the dominant paradigms predict that agents need capital markets the most, agents cannot borrow at all. A growing literature aiming to explain Sudden Stops emerged in recent years. The starting point of this literature is to replace the assumption of perfect credit markets with plausible financial frictions. Despite important progress in theoretical work, three key issues are still unresolved: (a) Sudden Stops are modeled as large, unexpected shocks. In most Sudden Stop models (for example,

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♣ We are very much endebted to Per Krusell for encouragement and advice. We particularly thank Alan Stockman for his suggestions. For useful comments we thank Rafael Del Villar. All errors are our own. The opinions contained in this document correspond exclusively to the authors and do not necessarily represent the views of Banco de Mé xico.

Among the characteristics that distinguish most developing countries, compared to the large industrialized countries, are: greater exposure to supply shocks in general and trade volatility in particular, procyclicality of both domestic fiscal policy and international finance, lower credibility with respect to both price stability and default risk, and other imperfect institutions. Models of dynamic inconsistency in monetary policy and the need for central bank independence and commitment to nominal targets apply even more strongly to developing countries. But because most developing countries are price-takers on world markets, the small open economy model, with nontraded goods, is often more useful than the two-country two-good model. Contractionary effects of devaluation are also far more important for developing countries, particularly the balance sheet effects that arise from currency mismatch. The exchange rate was the favored nominal anchor for monetary policy in inflation stabilizations of the late 1980s and early 1990s. After the currency crises of

Investment necessary for growth is risky and often requires external financing. For an emerging market, access to international credit markets is volatile and interest rates reflect risk of default. We present a theoretical model in which emerging market agents have access to a profitable two-period investment project of fixed size greater than their endowment. Credit market imperfections can magnify a small solvency problem into a financial crisis with widespread default and/or currency devaluation. In equilibrium, creditors o¤er single-period debt up to a ceiling based on expected future output. News about a negative productivity shock reduces the debt ceiling imposed by creditors, creating a sudden stop of capital ‡ows. The sudden stop can be severe enough to trigger a debt crisis, when agents prefer default over debt repayment, and/or a currency crisis, as agents attempt to maintain desired consumption by swapping domestic currency for foreign currency to purchase goods. We also show that there are critical thresholds for parameters governing credit market imperfections that separate countries into a safe credit club with low interest rates and steady access and a risky club with high interest rates and volatile access.

This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. This paper shows that the dominant view that the high variability of real exchange rates is due to movements in exchange rate-adjusted prices of tradable goods does not hold for Mexican data for periods with a managed exchange rate. The relative price of nontradables accounts for up to 70 percent of real exchangerate variability during these periods. The paper also proposes a model in which this fact, and the sudden stops that accompanied the collapse of Mexico’s managed exchange rates, could result from a Fisherian debt-deflation mechanism operating via nontradables prices in economies with dollarized liabilities.

The characteristics that distinguish most developing countries, compared to large industrialized countries, include: greater exposure to supply shocks in general and trade volatility in particular, procyclicality of both domestic fiscal policy and international finance, lower credibility with respect to both price stability and default risk, and other imperfect institutions. These characteristics warrant appropriate models. Models of dynamic inconsistency in monetary policy and the need for central bank independence and commitment to nominal targets apply even more strongly to developing countries. But because most developing countries are price-takers on world markets, the small open economy model, with nontraded goods, is often more useful than the two-country two-good model. Contractionary effects of devaluation are also far more important for developing countries, particularly the balance sheet effects that arise from currency mismatch. The exchange rate was the favored nominal anchor for monetary policy in inflation stabilizations of the late 1980s and early 1990s. After the currency crises of 1994-2001, the conventional wisdom anointed Inflation Targeting as the preferred monetary regime in place of exchange

has an expertise in banking, capital market, macroeconomic policies and economic research. She is currently coordinating an ADB regional technical assistant on financial research

Expansionary macroeconomic policies were adopted worldwide in response to the financial crisis. These policies aimed at stabilising financial conditions and fostering the economic recovery. However, the abundant global liquidity, together with the improvement in economic prospects in emerging markets, have led to a two-speed recovery in which emerging