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Sudden Stops in Emerging Economies: The Role of World Interest Rates and Foreign Exchange Intervention

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  • J. Scott Davis
  • Michael B. Devereux
  • Changhua Yu

Abstract

Emerging economies are prone to ‘sudden stops’, characterized by a collapse in external borrowing and aggregate demand. Sudden stops may be triggered by a spike in world interest rates, which causes rapid private sector deleveraging. In response to a rise in interest rates, deleveraging is individually rational, but in the aggregate, the effect on the real exchange rate may tighten borrowing constraints so much that it precipitates a large crisis. A central bank can intervene by selling foreign reserves when world interest rates are rising, and prevent excess aggregate deleveraging. But the central bank cannot borrow reserves. Then, to intervene during a crisis, the central bank must acquire reserves in advance, which is costly. The optimal reserve management policy trades off the insurance benefits of reserves during a crisis against the welfare costs of accumulating reserves before a crisis.

Suggested Citation

  • J. Scott Davis & Michael B. Devereux & Changhua Yu, 2020. "Sudden Stops in Emerging Economies: The Role of World Interest Rates and Foreign Exchange Intervention," Globalization Institute Working Papers 405, Federal Reserve Bank of Dallas, revised 10 Sep 2021.
    • Handle: RePEc:fip:feddgw:89034
    DOI: 10.24149/gwp405r1
    Note: An earlier version of this paper circulated under the title "Sudden Stops and Optimal Foreign Exchange Intervention."
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    More about this item

    Keywords

    Central bank; sudden stops; foreign exchange interventions;
    All these keywords.

    JEL classification:

    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
    • E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
    • F40 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - General
    • F30 - International Economics - - International Finance - - - General

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