Sudden stops and reserve accumulation in the presence of liquidity risk

Flora Lutz, Leopold Zessner-Spitzenberg

Publications: Working paper

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.
Original languageEnglish
Number of pages53
Publication statusPublished - Sep 2019

Publication series

SeriesVienna Economics Papers
Number1907

Austrian Fields of Science 2012

  • 502053 Economics

Keywords

  • International reserves
  • Sudden stops
  • Liquidity
  • Young Economist Award 19

    Zessner-Spitzenberg, Leopold (Recipient) & Lutz, Flora (Recipient), 6 Dec 2019

    Prize: Prize, award or honor

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