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Wieladek and participants at several conferences and seminars for their useful comments. We thank numerous officials at …nance ministries, central banks, national statistical agencies, and the IMF for their assistance in compiling the dataset. Giagkos Alexopoulos, Florian Blum and Daniel Osorio-Rodriguez provided excellent research assistance. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peerreviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.

Financial crashes were followed by deep recessions in the Sudden Stops of emerging economies. An equilibrium business cycle model with a collateral constraint explains this phenomenon as a result of the amplification and asymmetry that the constraint induces in the responses of macro-aggregates to shocks. Leverage rises during expansions, and when it rises enough it triggers the constraint, causing a Fisherian deflation that reduces credit and the price and quantity of collateral assets. Output and factor allocations fall because access to working capital financing is also reduced. Precautionary saving makes Sudden Stops low probability events nested within normal cycles, as observed in the data. (JEL E21, E23, E32, E44, G01, O11, O16)

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for their comments, and Dio Kaltis for high-quality research assistance. This paper represents only the authors' views and not those of the International Monetary Fund, its Executive Board, its Management, or the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peerreviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.

for helpful comments and suggestions. We also acknowledge comments by participants at various seminars and conferences. † This version of the paper was prepared while Enrique Mendoza was a visiting scholar with the Research Department, and he is grateful for Department's hospitality and support. Emerging markets business cycle models treat default risk as part of an exogenous interest rate on working capital, while sovereign default models treat income fluctuations as an exogenous endowment process with ad-noc default costs. We propose instead a general equilibrium model of both sovereign default and business cycles. In the model, some imported inputs require working capital financing; default on public and private obligations occurs simultaneously. The model explains several features of cyclical dynamics around default triggers an efficiency loss as these inputs are replaced by imperfect substitutes; and default on public and private obligations occurs simultaneously. The model explains several features of cyclical dynamics around deraults, countercyclical spreads, high debt ratios, and key business cycle moments. This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

Global financial imbalances can result from financial integration when countries differ in financial markets development. Countries with more advanced financial markets accumulate foreign liabilities in a gradual, long-lasting process. Differences in financial development also affect the composition of foreign portfolios: countries with negative net foreign asset positions maintain positive net holdings of nondiversifiable equity and foreign direct investment. Three observations motivate our analysis: (1) financial development varies widely even among industrial countries, with the United States on top; (2) the secular decline in the U.S. net foreign asset position started in the early 1980s, together with a gradual process of international financial integration; (3) the portfolio composition of U.S. net foreign assets features increased holdings of risky assets and a large increase in debt. (c) 2009 by The University of Chicago. All rights reserved..

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