Working Paper: NBER ID: w12564
Authors: Enrique G. Mendoza
Abstract: The current account reversals, large recessions, and price collapses that define Sudden Stops contradict the predictions of a large class of models in which the current account is a vehicle for consumption smoothing and investment financing. This paper shows that the quantitative predictions of a business cycle model with collateral constraints are consistent with the key features of Sudden Stops. Standard shocks to imported input prices, the world interest rate, and productivity trigger collateral constraints on debt and working capital when borrowing levels are high relative to asset values, and these high-leverage states are endogenous outcomes. In these situations, Irving Fisher's debt-deflation mechanism causes Sudden Stops as the deflation of Tobin's Q leads to a spiraling decline in the prices and holdings of collateral assets. This has immediate effects on output and factor demands because collapsing collateral values cut access to working capital. In contrast with previous findings, collateral constraints induce significant amplification in the responses of macroaggregates to shocks. Because of precautionary saving, Sudden Stops are infrequent events nested within normal cycles in the long run, but they remain a positive probability event.
Keywords: Sudden Stops; Collateral Constraints; Business Cycle Models; Fisherian Deflation; Tobin's Q
JEL Codes: D52; E44; F32; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| collateral constraints (D10) | amplification of macroeconomic responses to shocks (F41) |
| high leverage states (H74) | amplification of macroeconomic responses to shocks (F41) |
| shocks to imported input prices (F16) | collateral constraints (D10) |
| shocks to world interest rate (E43) | collateral constraints (D10) |
| shocks to productivity (O49) | collateral constraints (D10) |
| collateral constraints (D10) | sudden stop (F32) |
| sudden stop (F32) | sharp reversal in current account (F32) |
| sudden stop (F32) | deep recessions (E32) |
| sudden stop (F32) | collapses in asset prices (G19) |
| decline in Tobin's Q (D25) | reductions in investment (G31) |
| decline in Tobin's Q (D25) | reductions in asset prices (G19) |
| reductions in investment (G31) | further reductions in asset prices (G19) |
| further reductions in asset prices (G19) | exacerbation of economic downturns (F44) |
| sudden stops (F32) | declines in consumption (D12) |
| sudden stops (F32) | larger current account reversals (F32) |