Abstract

Emerging markets in the 1990s experienced periods of booms followed by collapses in gross domestic product, consumption, traded and non-traded sector output and real exchange rate movements alongside unprecedented movements in foreign investor participation in these economies. An important feature of these episodes is the asymmetry in the pattern of booms and collapses. We introduce a natural search friction into the foreign investment decision in a small open economy and demonstrate that this can generate the asymmetry observed in the data. The magnitude of the reversals predicted by the model can be quantitatively large and empirically relevant.

Highlights

  • Emerging market economies in the nineteen nineties have experienced periods of booms followed by collapses in gross domestic product, consumption, traded and non-traded sector output and real exchange rate movements alongside unprecedented movements in foreign investor participation in these economies

  • If we compare the steady state welfare of an economy in which households can trade in the risk-free bond but there are no searching foreign investors, to the steady state welfare of the economy we describe in this paper, the welfare gains are very large11

  • We demonstrate that in the presence of a search friction in foreign investors entry decision into emerging markets there arises a natural asymmetry in the adjustment process of the economy to shocks

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Summary

Introduction

Emerging market economies in the nineteen nineties have experienced periods of booms followed by collapses in gross domestic product, consumption, traded and non-traded sector output and real exchange rate movements alongside unprecedented movements in foreign investor participation in these economies. Since the empirical evidence on intertemporal substitution is weak, Rebelo-Vegh (1995) who survey explanations based on exchange rate based stabilizations in high inßation economies conclude that it is “very difficult to explain the magnitude of the real appreciation and consumption booms” on the basis of these explanations These papers do not address the asymmetric adjustment that we observe. The prolonged appreciation in the real exchange rate and gradual expansion in GDP, traded sector output and measure of active projects, in response to an improvement in investment fundamentals is a consequence of the optimal decisions of investors to wait and seek good matches. In response to a deterioration in fundamentals, previously good matches provide inadequate returns and one observes a sudden rise in project destruction that in turn generates the asymmetrically sharp contraction in GDP, traded sector output, measure of active projects and real exchange rate.

The Model
The Foreign Investor
The Domestic Household
Aggregation and Market Clearing Conditions
Parameter Values
The Economy in Steady State
Asymmetric Responses
Findings
Conclusion
Full Text
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