A Fisherian Approach to Financial Crises: Lessons from the Sudden Stops Literature

60 Pages Posted: 22 Jul 2020

See all articles by Enrique G. Mendoza

Enrique G. Mendoza

National Bureau of Economic Research (NBER); University of Pennsylvania

Javier Bianchi

Federal Reserve Banks - Federal Reserve Bank of Minneapolis

Multiple version iconThere are 2 versions of this paper

Date Written: June 30, 2020

Abstract

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

Mendoza, Enrique G. and Bianchi, Javier, A Fisherian Approach to Financial Crises: Lessons from the Sudden Stops Literature (June 30, 2020). PIER Working Paper No. 20-027, Available at SSRN: https://ssrn.com/abstract=3657199 or http://dx.doi.org/10.2139/ssrn.3657199

Enrique G. Mendoza (Contact Author)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
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University of Pennsylvania ( email )

Philadelphia, PA 19104
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HOME PAGE: http://www.sas.upenn.edu/~egme/index.html

Javier Bianchi

Federal Reserve Banks - Federal Reserve Bank of Minneapolis ( email )

90 Hennepin Avenue
Minneapolis, MN 55480
United States

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