Financial Crises, Capital Liquidation and the Demand for International Reserves

41 Pages Posted: 18 Nov 2009

See all articles by Alexandros Mourmouras

Alexandros Mourmouras

International Monetary Fund (IMF) - Policy Development and Review Department

Steven H. Russell

Indiana University Purdue University Indianapolis (IUPUI) - Department of Economics

Date Written: November 17, 2009

Abstract

We study a simple neoclassical model of investment in a developing country, modified to allow for long-term projects and short-term debt. Early signals indicating low productivity of investment may lead creditors to call loans in early. In such a crisis, firms protected by limited liability default and liquidate capital, even thought they do so at a loss (a “fire sale”). We show that short-term debt financing is beneficial in good (normal) times: when there is no adverse signal, and thus no need to liquidate capital, investment, the capital-labor ratio, wages and ex post worker utility are all higher than they would be if liquidation were not possible or was prohibited. Capital liquidation exacerbates the effects of negative shocks by lowering the capital-labor ratio and lowering wages in bad times (crises). Capital liquidation raises the variability of wages and hurts workers who cannot insure against wage income (this seems plausible in emerging market economies). Accumulating a stock of international reserves to be used during or after a crisis can mitigate the adverse effects of capital liquidation on wage variability and worker welfare.

Suggested Citation

Mourmouras, Alexandros and Russell, Steven H., Financial Crises, Capital Liquidation and the Demand for International Reserves (November 17, 2009). Available at SSRN: https://ssrn.com/abstract=1507639 or http://dx.doi.org/10.2139/ssrn.1507639

Alexandros Mourmouras (Contact Author)

International Monetary Fund (IMF) - Policy Development and Review Department ( email )

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Steven H. Russell

Indiana University Purdue University Indianapolis (IUPUI) - Department of Economics ( email )

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Indianapolis, IN 46202
United States
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