From Sudden Stops to Fisherian Deflation: Quantitative Theory and Policy

Abstract

In the 1990s, Sudden Stops in emerging markets were a harbinger of the 2008 global financial crisis. During these Sudden Stops, countries lost access to credit, which caused abrupt current account reversals, and suffered severe recessions. This article reviews a class of models that yield quantitative predictions consistent with these observations, based on an occasionally binding credit constraint that limits debt to a fraction of the market value of incomes or assets used as collateral. Sudden Stops are infrequent events nested within regular business cycles and occur in response to standard shocks after periods of expansion increase leverage ratios sufficiently. When this happens, the Fisherian debt-deflation mechanism is set in motion, as lower asset or goods prices tighten the constraint further, causing further deflation. This framework also embodies a pecuniary externality with important implications for macroprudential policy because agents do not internalize how current borrowing decisions affect collateral values during future financial crises.