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Sudden Stops in a Business Cycle Model with Credit Constraints: a Fisherian Deflation of Tobin's Q

Sudden Stops are characterized by large current account reversals, severe recessions, and corrections in relative prices. This phenomenon is a puzzle for a large class of business cycle models in which the current account is a vehicle for consumption smoothing and investment financing. Models in this class explain Sudden Stops as the result of large, unanticipated shocks to credit market access, but this explanation is at odds with the history of Sudden Stops and is incomplete because it obtains the current account reversal by assumption. Why economies in which agents know that Sudden Stops can happen become vulnerable to these crises? Can equilibrium business cycle theory explain infrequent Sudden Stops nested within “normal” business cycles without recurring to large, unexpected shocks? This paper answers these questions by constructing a model in which typical realizations of exogenous shocks to the price of imported intermediate goods, the world interest rate, and productivity can trigger credit constraints on foreign debt and working capital. This occurs only when agents are highly indebted, and these high-debt states are endogenous outcomes reached with positive probability in the long run. Sudden Stop dynamics are driven by endogenous financing premia on foreign debt and working capital and Fisher’s debt-deflation mechanism. The latter amplifies the effects of adverse shocks hitting the economy and increases their persistence.