Working Paper: NBER ID: w26402
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: Household heterogeneity; Foreign shocks; Exchange rate policy; Consumption contraction
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 |
|---|---|
| Higher leverage (G19) | Larger contractions in consumption (E21) |
| Foreign currency debt revaluation (F31) | Larger aggregate consumption contractions (E20) |
| Exchange rate devaluation (F31) | Detrimental impact on household welfare (D19) |
| Fixed exchange rate (F31) | Mitigates adverse balance sheet effects from foreign currency debt revaluation (F31) |