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A Fisherian Approach to Financial Crises: Lessons from the Sudden Stops Literature

Working Paper 765 | Published April 1, 2020

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Authors

Enrique G. Mendoza University of Pennsylvania

A Fisherian Approach to Financial Crises: Lessons from the Sudden Stops Literature

Abstract

Sudden Stops are financial crises defined by a large, sudden current-account reversal. They occur in both advanced and emerging economies and result in deep recessions, collapsing asset prices, and real exchange-rate depreciations. They are preceded by economic expansions, current-account deficits, credit booms, and appreciated asset prices and real exchange rates. Fisherian models (i.e. models with credit constraints linked to market prices) explain these stylized facts as an outcome of Irving Fisher's debt-deflation mechanism. On the normative side, these models feature a pecuniary externality that provides a foundation for macroprudential policy (MPP). We review the stylized facts of Sudden Stops, the evidence on MPP use and effectiveness, and the findings of the literature on Fisherian models. Quantitatively, Fisherian amplification is strong and optimal MPP reduces sharply the size and frequency of crises, but it is also complex and potentially time-inconsistent, and simple MPP rules are less effective. We also provide a new MPP analysis incorporating investment. Using a constant debt-tax policy, we construct a crisis probability-output frontier showing that there is a tradeoff between financial stability and long-run output (i.e., reducing the probability of crises reduces long-run output).


Published in _Review of Economic Dynamics_ (Vol. 37, Supp. 1, August 2020, pp. S254-283), https://doi.org/10.1016/j.red.2020.06.001.