Fighting Against Currency Depreciation, Macroeconomic Instability, and Sudden Stops

Abstract

In this paper we show that in the aftermath of a crisis, a government that changes the nominal interest rate in response to currency depreciation can induce aggregate instability in the economy by generating self-fulfilling endogenous cycles. In particular if a government raises the interest rate proportionally more than an increase in currency depreciation then it induces self-fulfilling cyclical equilibria that are able to replicate some of the empirical regularities of emerging market crises. We construct an equilibrium characterized by the self-validation of people's expectations about currency depreciation and by the following stylized facts of the "Sudden Stop" phenomenon: a decline in domestic production and aggregate demand, a significantly larger currency depreciation, a collapse in asset prices, a sharp correction in the price of traded goods relative to non-traded goods and an improvement in the current account deficit.