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

Lutz, Flora and Zessner-Spitzenberg, Leopold (2019) Sudden Stops and Reserve Accumulation in the Presence of International Liquidity Risk. University of Vienna, Department of Economics, Vienna Economics Papers 1907, 53 p.

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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 ineffciency 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.

Item Type: Discussion/ Working Paper (Unspecified)
Keywords: international reserves, sudden stops, liquidity, macroprudential policy, pecuniary externalities
Funders: Vienna Graduate School of Economics funded by the Austrian Science Fund (FWF): W 1264 Doktoratskollegs
Classification Codes (e.g. JEL): D62, E44, F32, F34, F41
Research Units: Former Research Units (until 2020) > Macroeconomics and Economic Policy
Date Deposited: 20 Jan 2020 09:47
Last Modified: 21 Feb 2024 12:34

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