Working Paper: NBER ID: w28079
Authors: J. Scott Davis; Michael B. Devereux; Changhua Yu
Abstract: We model sudden stops in a small open economy as rare discrete events precipitated by increases in the world risk-free rate. When external debt is large, the model exhibits multiple equilibria, one where external debt and consumption remain high, and one with a collapse in external debt and consumption. Private agents delever following an increase in the world interest rate, but they fail to internalize the impact of deleveraging on the price of collateral. For high levels of debt, even a small increase in the world interest rate can eliminate the high debt equilibrium and the economy experiences a sudden stop. The central bank can use foreign exchange intervention to prevent the sudden stop. If reserves cannot be borrowed, optimal policy is to “lean against the wind”, buying foreign reserves ex-ante when private borrowing is high and selling them after an interest rate shock when private agents are deleveraging.
Keywords: sudden stops; foreign exchange intervention; emerging markets; world interest rates
JEL Codes: E30; E50; F40
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increase in world risk-free rate (E43) | Sudden stop (F32) |
| Sudden stop (F32) | Collapse in external debt (F65) |
| Sudden stop (F32) | Collapse in consumption (D12) |
| Failure of private agents to internalize deleveraging effects (F65) | Sudden stop (F32) |
| Foreign exchange intervention (F31) | Stabilization of consumption (E21) |
| Foreign exchange intervention (F31) | Stabilization of external debt (F34) |
| Binding collateral constraint (G33) | Sudden stop (F32) |
| Optimal policy (buying foreign reserves) (F31) | Prevention of sudden stops (C41) |