Working Paper: NBER ID: w10940
Authors: Enrique G. Mendoza; Katherine A. Smith
Abstract: This paper shows that the quantitative predictions of an equilibrium asset pricing model with financial frictions are consistent with the large consumption and current-account reversals and asset-price collapses observed in the "Sudden Stops" of emerging markets crises. Margin requirements set a collateral constraint on foreign borrowing by domestic agents. Foreign traders incur costs in trading assets with domestic agents. Margin constraints bind occasionally depending on equilibrium portfolios and asset prices. When the constraints do not bind, productivity shocks cause standard real-business-cycle effects. When the constraints bind, shocks of the same magnitude cause strikingly different effects that vary with the leverage ratio and the liquidity of asset markets. With high leverage and liquid markets, the shocks trigger margin calls forcing "fire sales" of assets. Fisher's debt-deflation mechanism causes subsequent rounds of margin calls, a fall in asset prices and large consumption and current account reversals. The size of the price decline depends on trading costs parameters because these parameters determine the price elasticity of the foreign traders' asset demand function. Price declines of the magnitude observed in the data require a less-than-unitary price elasticity. Precautionary saving makes Sudden Stops infrequent in the long run so that the model can explain both regular business cycles and the unusually large reversals of consumption and current accounts associated with Sudden Stops.
Keywords: debt-deflation; sudden stops; asset prices; financial frictions
JEL Codes: F41; F32; E44; D52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| margin requirements (G32) | collateral constraints (D10) |
| collateral constraints (D10) | margin calls (E44) |
| margin calls (E44) | fire sales of assets (G33) |
| fire sales of assets (G33) | decline in asset prices (G19) |
| decline in asset prices (G19) | further rounds of margin calls (E44) |
| high leverage and liquidity (G19) | larger reversals in consumption and current accounts (F32) |
| larger reversals in consumption and current accounts (F32) | sudden stops (F32) |