Abstract
Emerging Market economies have experienced periods of gradual and persistent appreciation in the real exchange rate, persistent current account deficits alongside high levels of foreign investment flows in an expansion phase followed by a contractionary phase of a sharp downward correction in the real exchange rate and sharp reversals in foreign investment flows. We introduce a natural search friction into the foreign investment decision in a small open economy and demonstrate that this can explain both the period of prolonged real appreciation and the asymmetrically sharp downward adjustment in the correction phase. The adjustment hazard model of investment we present generates predictions that differ significantly from the standard q model of investment with quadratic adjustment costs.
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
Summary
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.
Sign-in/Register to view highlights & summary Sign-in/Register to access full text options 
Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have
Schedule a callDisclaimer: All third-party content on this website/platform is and will remain the property of their respective owners and is provided on "as is" basis without any warranties, express or implied. Use of third-party content does not indicate any affiliation, sponsorship with or endorsement by them. Any references to third-party content is to identify the corresponding services and shall be considered fair use under The CopyrightLaw.
