Precautionary Demand for Foreign Assets in Sudden Stop Economies: An Assessment of the New Merchantilism

47 Pages Posted: 27 Jun 2007 Last revised: 15 Aug 2007

See all articles by Ceyhun Bora Durdu

Ceyhun Bora Durdu

Board of Governors of the Federal Reserve System

Enrique G. Mendoza

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

Marco E. Terrones

International Monetary Fund (IMF)

Multiple version iconThere are 2 versions of this paper

Date Written: May 2007

Abstract

Financial globalization was off to a rocky start in emerging economies hit by Sudden Stops since the mid 1990s. Foreign reserves grew very rapidly during this period, and hence it is often argued that we live in the era of a New Merchantilism in which large stocks of reserves are a war-chest for defense against Sudden Stops. We conduct a quantitative assessment of this argument using a stochastic intertemporal equilibrium framework with incomplete asset markets in which precautionary saving affects foreign assets via three mechanisms: business cycle volatility, financial globalization, and Sudden Stop risk. In this framework, Sudden Stops are an equilibrium outcome produced by an endogenous credit constraint that triggers Irving Fisher's debt-deflation mechanism. Our results show that financial globalization and Sudden Stop risk are plausible explanations of the observed surge in reserves but business cycle volatility is not. In fact, business cycle volatility has declined in the post-globalization period. These results hold whether we use the formulation of intertemporal preferences of the Bewley-Aiyagari-Hugget class of precautionary savings models or the Uzawa-Epstein setup with endogenous time preference.

Suggested Citation

Durdu, Ceyhun Bora and Mendoza, Enrique G. and Terrones, Marco E., Precautionary Demand for Foreign Assets in Sudden Stop Economies: An Assessment of the New Merchantilism (May 2007). NBER Working Paper No. w13123, Available at SSRN: https://ssrn.com/abstract=988934

Ceyhun Bora Durdu

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States
2024523775 (Phone)

HOME PAGE: http://www.ceyhunbora.com

Enrique G. Mendoza (Contact Author)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

University of Pennsylvania ( email )

Philadelphia, PA 19104
United States

HOME PAGE: http://www.sas.upenn.edu/~egme/index.html

Marco E. Terrones

International Monetary Fund (IMF) ( email )

700 19th Street NW
Washington, DC 20431
United States
202-623-4329 (Phone)

HOME PAGE: http://imf.org/external/np/CV/AuthorCV.aspx?AuthID=171

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