Non-Homothetic Sudden Stops

Abstract

The expenditure elasticity of the demand for nontradable goods is higher than the one for
tradable goods. We extend the small open economy model of Sudden Stops of Bianchi (2011)
allowing for non-homothetic preferences to generate this difference. Analytic results for an endowment economy show that, during crises, the non-homotheticity amplifies the decrease in the demand for the nontradable good, triggering a sharper deflation spiral that ultimately leads
to a more severe current account reversal. The amplified pecuniary externality calls for more
aggressive debt taxes. An extended version of the model with production and permanent productivity shocks shows that non-homothetic preferences can also amplify the credit booms that
precede Sudden Stops. The amplification is particularly large when the consumption boom is
biased toward nontradable goods. Macroprudential policy shows, not only quantitative, but
also qualitative differences in its reaction to shocks under preference non homotheticity.

Keywords: Macroprudential policy, Expenditure elasticity, Financial crises

JEL Classification: E31, E37, E52, F41