Working Paper: CEPR ID: DP14062
Authors: Sergio De Ferra; Kurt Mitman; Federica Romei
Abstract: We study the role of heterogeneity in the transmission of foreign shocks. We build a Heterogeneous-Agent New-Keynesian Small Open Model Economy (HANKSOME) that experiences a current account reversal. Households' portfolio composition and the extent of foreign currency borrowing are key determinants of the magnitude of the contraction in consumption associated with a sudden stop in capital inflows. The contraction is more severe when households are leveraged and owe debt in foreign currency. In this setting, the revaluation of foreign debt causes a larger contraction in aggregate consumption when debt and leverage are concentrated among poorer households. Closing the output gap via an exchange-rate devaluation may therefore be detrimental to household welfare due to the heterogeneous impact of the foreign debt revaluation. Our HANKSOME framework can rationalize the observed "fear of floating" in emerging market economies, even in the absence of contractionary devaluations.
Keywords: sudden stops; foreign currency debt; exchange rate policy; incomplete markets
JEL Codes: E21; F32; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| household heterogeneity (D19) | transmission of foreign shocks (F42) |
| portfolio composition and foreign currency borrowing (G15) | magnitude of consumption contraction (E20) |
| foreign currency debt revaluation (F31) | contraction in aggregate consumption (E20) |
| household leverage and foreign currency debt (F65) | contraction in consumption (E21) |
| exchange rate devaluation (F31) | household welfare (I38) |
| foreign debt revaluation (F34) | household welfare (I38) |
| household financial structure (G59) | economy's response to external shocks (F41) |