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The authors would like to thank Lynne Evans, Hugh Metcalf, Peter Sinclair, Mike Wickens and seminar participants at Newcastle University and participants at the MMF 2009 Annual Conference for comments and suggestions.
See, Reinhart and Rogoff (2009) for a comprehensive evaluation of the differences between the current and previous experiences of financial crises.
Kiyotoki and Moore (1997) introduce financial frictions through binding collateral constraints. In this framework, financial constraints arise because lenders cannot force borrowers to repay their debt, and thus physical assets are used as collateral for the borrowing. Christiano and others (2004) and Braggion and others (2009) are prominent examples that follow this subset of literature.
This is motivated by the considerable empirical evidence of pricing-to-market and incomplete exchange rate pass-through for small open economies as analyzed by Naug and Nymoen (1996) and Campa and Goldberg (2005). See also Goldberg and Knetter (1997) for a detailed survey.
Note that, when γ = 1, openness of the economy is given by (1–α), the consumption index takes the form
This premium is introduced for technical reasons to maintain the stationarity in the economy’s net foreign assets, following Schmitt-Grohe and Uribe (2003).
For simplicity, we normalize
The idiosyncratic productivity is assumed to be distributed log-normally;
In Curdia (2007, 2008), the perception factor is kept at its low state value during the sudden stop periods, but there is a certain probability of exiting a sudden stop. Instead, we assume that the perception factor gradually goes back to its steady state level (ς = 1)
The nonstochastic steady state of the model is solved numerically in MATLAB, and then the second order approximation of the model and the stochastic simulations are computed using Michel Juillard’s software Dynare. Details of the computation of the nonstochastic steady state and the stationary model equations are available upon request.
Hence, the domestic economy is assumed to be more vulnerable to changes in financial conditions. The fact that advanced economies have deeper and more sophisticated financial markets implies, however, that there are likely to be better financing opportunities for firms in these economies, presumably leading to a higher economy-wide leverage. Nevertheless, international evidence suggests that leverage in general and foreign currency borrowing in particular is higher in emerging market countries, which makes the financial systems in these economies much more fragile than the ones in mature economies (see, for example, IMF, 2008).
The impulse responses show the responses of the economy to a 2 percent (negative) misperception shock. The variables are presented as log deviations from the steady state, multiplied by 100 to have an interpretation of percentage deviations.
The fall in output in the first quarter of 2009 as compared with a year earlier was 10.1, 10.2 and 13.8 percent for Singapore, Taiwan Province of China, and Turkey, respectively. Similarly, Germany and Japan, that are among the most open of mature economies, contracted by 6.9 and 8.8 percent, respectively over the same period (The Economist, July 4, 2009).