Capital Flows and Capital-Market Crises: The Simple Economics of Sudden Stops

Abstract

The paper studies mechanisms through which a sudden stop in international credit flows may bring about financial and balance of payments crises. It is shown that these crises can occur even though the current account deficit is fully financed by foreign direct investment. However, equity and long-term bond financing may shield the economy from sudden stop crises. The paper also examines possible factors that could trigger sudden stops, and argues that the greater independence that countries have, as compared to regions of a given country, could help to explain why sudden stop crises are more prevalent and destructive at international than at national levels.