Sudden Stops and Reserve Accumulation in the Presence of International Liquidity Risk

Flora Lutz () and Leopold Zessner-Spitzenberg ()
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Flora Lutz: https://econ.univie.ac.at
Leopold Zessner-Spitzenberg: https://econ.univie.ac.at

Vienna Economics Papers from University of Vienna, Department of Economics

Abstract: We propose a small open economy model where agents borrow internationally and invest in liquid foreign assets to insure against liquidity shocks, which temporarily shut out the economy of short-term credit markets. Due to the presence of a pecuniary externality individual agents borrow too much and hold too little liquid assets relative to a social planner. This inefficiency rationalizes macroprudential policy interventions in the form of reserve accumulation at the central bank coupled with a tax on foreign borrowing. Unless combined with other measures, a tax on foreign borrowing is detrimental to welfare; it reduces agents’ incentives to invest in liquid assets and thereby increases financial instability. Our model can quantitatively match the simultaneous depreciation of the exchange rate and contractions in output, gross trade flows, foreign liabilities and liquid reserves during Sudden Stop episodes.

JEL-codes: D62 E44 F32 F34 F41 (search for similar items in EconPapers)
Date: 2019-09
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