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

57 Pages Posted: 13 Nov 2020 Last revised: 11 Jan 2022

See all articles by Scott Davis

Scott Davis

Federal Reserve Banks - Federal Reserve Bank of Dallas

Michael Devereux

Schroders Investment Management

Changhua Yu

Peking University

Multiple version iconThere are 2 versions of this paper

Date Written: November, 2020

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.

Keywords: Central bank, sudden stops, foreign exchange interventions

JEL Classification: E50, E30, F40, F30

Suggested Citation

Davis, Scott and Devereux, Michael and Yu, Changhua, Sudden Stops in Emerging Economies: The Role of World Interest Rates and Foreign Exchange Intervention (November, 2020). Globalization Institute Working Paper No. 405, Available at SSRN: https://ssrn.com/abstract=3729668 or http://dx.doi.org/10.24149/gwp405r1

Scott Davis (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Dallas ( email )

2200 North Pearl Street
PO Box 655906
Dallas, TX 75265-5906
United States

Michael Devereux

Schroders Investment Management ( email )

31 Gresham Street
London, EC2V 7QA
United Kingdom

Changhua Yu

Peking University ( email )

China Center for Economic Research
National School of Development, Peking University
Beijing, 100871
China

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