Sudden Stops in Emerging Economies: The Role of World Interest Rates and Foreign Exchange Intervention

Abstract

Emerging economies are prone to ‘sudden stops’, characterized by a collapse in external borrowing and aggregate demand. Sudden stops may be triggered by a spike in world interest rates, which causes rapid private sector deleveraging. In response to a rise in interest rates, deleveraging is individually rational, but in the aggregate, the effect on the real exchange rate may tighten borrowing constraints so much that it precipitates a large crisis. A central bank can intervene by selling foreign reserves when world interest rates are rising, and prevent excess aggregate deleveraging. But the central bank cannot borrow reserves. Then, to intervene during a crisis, the central bank must acquire reserves in advance, which is costly. The optimal reserve management policy trades off the insurance benefits of reserves during a crisis against the welfare costs of accumulating reserves before a crisis.

Keywords: Central bank, sudden stops, foreign exchange interventions

JEL Classification: E50, E30, F40, F30