Board of Governors of the Federal Reserve System

International Finance Discussion Papers Number 848 December 2005

Fighting Against Currency Depreciation, Macroeconomic Instability and Sudden Stops

Luis-Felipe Zanna

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Fighting Against Currency Depreciation, Macroeconomic Instability and Sudden Stops∗
Luis-Felipe Zanna† First Draft: October 2002 This Draft: November 2005

Abstract In this paper we show that in the aftermath of a crisis, a government that changes the nominal interest rate in response to currency depreciation can induce aggregate instability in the economy by generating self-fulfilling endogenous cycles. In particular if a government raises the interest rate proportionally more than an increase in currency depreciation then it induces self-fulfilling cyclical equilibria that are able to replicate some of the empirical regularities of emerging market crises. We construct an equilibrium characterized by the self-validation of people’s expectations about currency depreciation and by the following stylized facts of the “Sudden Stop” phenomenon: a decline in domestic production and aggregate demand, a significantly larger currency depreciation, a collapse in asset prices, a sharp correction in the price of traded goods relative to non-traded goods and an improvement in the current account deficit. Keywords: Small Open Economy, Interest Rate Rules, Currency Depreciation, Multiple Equilibria, Sudden Stops, Collateral Constraints. JEL Classifications: