Posted by Connie R. Aponte on August 21, 2014 in FINANCIAL CRISES |

It must account for the high observed correlation between exchange rate collapses and banking crises. In the Southern Cone of the Americas in the early 1980s, Scandinavia in the early 1990s, Mexico in 1995 and Asia today, the currency crashed along with the financial system. Casual observation also suggests that the prices of assets (real estate, the stock market) tend to rise before a crash occurs. Formal econometric work, such as that reported by Kaminsky and Reinhart (1996), confirms that financial variables, unlike real ones, do seem to be reasonably good predictors of crises. Sachs, Tornell and Velasco (1996b), for instance, find that the previous speed of bank credit growth helped explain which countries were affected by the Tequila effect.

It must replicate the puzzling fact that the punishment is much larger than the crime. The real consequences of these crises are large: Chile’s GDP contracted by 14 percent in 1982, Mexico’s by almost 7 in 1995. The economies of once fast-growing Korea, Indonesia and Thailand are expected to shrink in 1998. Yet we saw above that not in all cases were the underlying macro fundamentals weak -and certainly not so weak as to justify the depressions observed in Chile and Mexico. A necessary correction in the current account of, say, 3 points of GDP naturally requires a contraction in aggregate demand, which in turn may be associated with higher interest rates and dampened activity. But no standard calibration of an RBC model requires real interest rates of 50 percent or higher to effect such a reduction in consumption and investment, and no standard sticky-price model can generate that kind of response of output to moderate changes in demand.

In this paper we offer a simple model that can satisfy the requirements just listed and replicate observed stylized facts. Our story places international illiquidity, which may result in outright collapse of the financial system, at the center of the problem. Illiquidity, defined as a situation in which the financial system’s potential short term obligations exceed the liquidation value of its assets, may emerge naturally as a response to some features of the environment. However, it may also make the system vulnerable to costly runs.

Any model in which financial entities issue demandable debt (for example, demand deposits) as a liability, therefore placing themselves in a potentially illiquid position, is a useful vehicle for our purpose. For concreteness we focus on an open economy version of the celebrated banking model by Bryant (1980) and Diamond and Dybvig (1983). In that model banks are essentially maturity transformers that take liquid deposits and invest part of the proceeds in illiquid assets. In doing so they pool risk and enhance welfare, but also create the possibility of self-fulfilling bank runs. action payday loan

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