Lending Booms, Sharp Reversals and Real Exchange Rate Dynamics
37 Pages Posted: 7 Nov 2001
Date Written: November 2, 2001
Emerging Market economies have experienced periods of gradual and persistent appreciation in the real exchange rate, persistent current account deficits alongside high levels of foreign investment flows in an expansion phase followed by a contractionary phase of a sharp downward correction in the real exchange rate and sharp reversals in foreign investment flows. We introduce a natural search friction into the foreign investment decision in a small open economy and demonstrate that this can explain both the period of prolonged real appreciation and the asymmetrically sharp downward adjustment in the correction phase. The adjustment hazard model of investment we present generates predictions that differ significantly from the standard q model of investment with quadratic adjustment costs.
JEL Classification: F3, F4
Suggested Citation: Suggested Citation