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

48 Pages Posted: 8 Oct 2006 Last revised: 31 Oct 2022

See all articles by Enrique G. Mendoza

Enrique G. Mendoza

National Bureau of Economic Research (NBER); University of Pennsylvania

Date Written: October 2006

Abstract

The current account reversals, large recessions, and price collapses that define Sudden Stops contradict the predictions of a large class of models in which the current account is a vehicle for consumption smoothing and investment financing. This paper shows that the quantitative predictions of a business cycle model with collateral constraints are consistent with the key features of Sudden Stops. Standard shocks to imported input prices, the world interest rate, and productivity trigger collateral constraints on debt and working capital when borrowing levels are high relative to asset values, and these high-leverage states are endogenous outcomes. In these situations, Irving Fisher's debt-deflation mechanism causes Sudden Stops as the deflation of Tobin's Q leads to a spiraling decline in the prices and holdings of collateral assets. This has immediate effects on output and factor demands because collapsing collateral values cut access to working capital. In contrast with previous findings, collateral constraints induce significant amplification in the responses of macroaggregates to shocks. Because of precautionary saving, Sudden Stops are infrequent events nested within normal cycles in the long run, but they remain a positive probability event.

Suggested Citation

Mendoza, Enrique G., Endogenous Sudden Stops in a Business Cycle Model with Collateral Constraints:A Fisherian Deflation of Tobin's Q (October 2006). NBER Working Paper No. w12564, Available at SSRN: https://ssrn.com/abstract=934759

Enrique G. Mendoza (Contact Author)

National Bureau of Economic Research (NBER) ( email )

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University of Pennsylvania ( email )

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