The Inside Baseball of Sudden Stop Models

Abstract

This paper examines the role of collateral in "sudden stop" models that feature occasionally binding constraints and endogenous growth. We show how different assumptions regarding the nature and valuation of collateral alter the dynamics of crisis episodes and the welfare costs of pecuniary externalities. For example, in a model with land as collateral, we show that valuing collateral at the "expected future price" leads to substantially weaker Fisherian deflation effects compared to the case with collateral valued at the "current price". However, the average size of sudden stops in the two economies is similar because households endogenously avoid the region where large sudden stops would occur. The difference between different collateral valuations and the size of sudden stops are amplified when we abstract from endogenous growth. In another case, assuming collateral is income rather than land leads to smaller sudden stops as income is less volatile than asset prices. Finally, we show that the efficiency distortions also change in terms of nature and policy implications; using the expected future price case the competitive equilibrium is efficient, while other cases feature a small distortion.

Keywords: sudden stops, collateral constraint, Fisherian deflation, growth