A Model of Financial Crises in Open Economies

Guido Lorenzoni () and Luigi Bocola

No 385, 2017 Meeting Papers from Society for Economic Dynamics

Abstract: We study a small open economy with flexible exchange rates and a financial sector that faces a potentially binding collateral constraint. Financial crises in the model are self-fulfilling, and they are associated to drops in real economic activity, real exchange rate depreciations, and current account reversals. The presence of dollarized liabilities in the financial sector makes these crises more likely. These currency mismatches arise endogenously because households have a precautionary motive to save in foreign currency when they expect a confidence crisis with sufficiently high probability. In this framework, we analyze the role of a domestic lender of last resort. Precautionary reserve accumulation by the monetary authority facilitates effective lending of last resort, and can lead to a less dollarized financial sector and to a more stable exchange rate.

Date: 2017
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed017:385

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