Essays on Preventing Sudden Stops
Essays on Preventing Sudden Stops
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Date
2006-05-30
Authors
Durdu, Ceyhun Bora
Advisor
Mendoza, Enrique G
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Abstract
Capital markets have witnessed a rash of `Sudden Stops' during the last decade.
Policy proposals to prevent these crises include creating indexed bond markets and
providing price guarantees for emerging market assets. Chapter 1 explores the
macroeconomic implications of indexed bonds with a return indexed to the key
variables driving emerging market economies such as terms of trade or productivity.
We employ a quantitative model of a small open economy in which Sudden Stops are
driven by the financial frictions inherent to world capital markets. While indexed
bonds provide a hedge to income fluctuations and can undo the effects of financial
frictions, they lead to interest rate fluctuations. Due to this tradeoff, there exists a
non-monotonic relation between the "degree of indexation" (i.e., the percentage of
the shock reflected in the return) and the overall effects of these bonds on macroe-
conomic fluctuations. Therefore, indexation can improve macroeconomic conditions
only if the degree of indexation is less than a critical value. When the degree of
indexation is higher than this threshold, it strengthens the precautionary savings
motive, increases consumption volatility and impact effect of Sudden Stops. The
threshold degree of indexation depends on the volatility and persistence of income
shocks as well as the relative openness of the economy.
Chapter 2 explores the implications of asset price guarantees provided by an
international financial organization on the emerging market assets. This policy is
motivated by the globalization hazard hypothesis, which suggest that Sudden Stops
caused by global financial frictions could be prevented by offering foreign investors
price guarantees on emerging markets assets. These guarantees create a trade-
off, however, because they weaken globalization hazard while creating international
moral hazard. We study this tradeoff using a quantitative, equilibrium asset-pricing
model. Without guarantees, margin calls and trading costs cause Sudden Stops
driven by a Fisherian deflation. Price guarantees prevent this deflation by propping
up foreign demand for assets. The effectiveness of price guarantees, their distor-
tions on asset markets, and their welfare implications depend critically on whether
the guarantees are contingent on debt levels and on the price elasticity of foreign
demand for domestic assets.