A Fisherian Approach to Financial Crises: Lessons from the Sudden Stops Literature
60 Pages Posted: 22 Jul 2020
Date Written: June 30, 2020
Sudden Stops are ﬁnancial crises deﬁned by a large, sudden current-account reversal. They occur in both advanced and emerging economies and result in deep recessions, collapsing asset prices, and real exchange-rate depreciations. They are preceded by economic expan-sions, current-account deﬁcits, credit booms, and appreciated asset prices and real exchange rates. Fisherian models (i.e. models with credit constraints linked to market prices) ex-plain these stylized facts as an outcome of Irving Fisher’s debt-deﬂation mechanism. On the normative side, these models feature a pecuniary externality that provides a foundation for macroprudential policy (MPP). We review the stylized facts of Sudden Stops, the evidence on MPP use and eﬀectiveness, and the ﬁndings of the literature on Fisherian models. Quantitatively, Fisherian ampliﬁcation is strong and optimal MPP reduces sharply the size and frequency of crises, but it is also complex and potentially time-inconsistent, and simple MPP rules are less eﬀective. We also provide a new MPP analysis incorporating investment. Using a constant debt-tax policy, we construct a crisis probability-output frontier showing that there is a tradeoﬀ between ﬁnancial stability and long-run output (i.e., reducing the probability of crises reduces long-run output).
Keywords: Sudden Stops, Financial crises, Macroprudential policy
JEL Classification: E31, E37, E52, F41
Suggested Citation: Suggested Citation