Working Paper: NBER ID: w13123
Authors: Ceyhun Bora Durdu; Enrique G. Mendoza; Marco E. Terrones
Abstract: Financial globalization was off to a rocky start in emerging economies hit by Sudden Stops since the mid 1990s. Foreign reserves grew very rapidly during this period, and hence it is often argued that we live in the era of a New Merchantilism in which large stocks of reserves are a war-chest for defense against Sudden Stops. We conduct a quantitative assessment of this argument using a stochastic intertemporal equilibrium framework with incomplete asset markets in which precautionary saving affects foreign assets via three mechanisms: business cycle volatility, financial globalization, and Sudden Stop risk. In this framework, Sudden Stops are an equilibrium outcome produced by an endogenous credit constraint that triggers Irving Fisher's debt-deflation mechanism. Our results show that financial globalization and Sudden Stop risk are plausible explanations of the observed surge in reserves but business cycle volatility is not. In fact, business cycle volatility has declined in the post-globalization period. These results hold whether we use the formulation of intertemporal preferences of the Bewley-Aiyagari-Hugget class of precautionary savings models or the Uzawa-Epstein setup with endogenous time preference.
Keywords: Financial Globalization; Sudden Stops; Foreign Assets; Precautionary Demand
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 |
|---|---|
| financial globalization (F30) | foreign asset holdings (G15) |
| sudden stop risk (E44) | foreign asset holdings (G15) |
| business cycle volatility (E32) | foreign asset holdings (G15) |