Quantitative implications of a debt-deflation theory of Sudden Stops and asset prices [An article from: Journal of International Economics]

by E.G. Mendoza, K.A. Smith

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This digital document is a journal article from Journal of International Economics, published by Elsevier in 2006. The article is delivered in HTML format and is available in your Amazon.com Media Library immediately after purchase. You can view it with any web browser.

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This paper shows that the quantitative predictions of an equilibrium asset-pricing model with financial frictions are consistent with key features of the Sudden Stop phenomenon. Foreign traders incur costs in trading assets with domestic agents, and a collateral constraint limits external debt to a fraction of the market value of domestic equity holdings. When this constraint does not bind, standard productivity shocks cause typical real-business-cycle effects. When it binds, the same shocks cause strikingly different effects depending on the leverage ratio and asset market liquidity. With high leverage and a liquid market, the shocks force ''fire sales'' of assets and Fisher's debt-deflation mechanism amplifies the responses of asset prices, consumption and the current account. Precautionary saving makes these Sudden Stops infrequent in the long run.

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