Non-Homothetic Sudden Stops

Abstract

Financial crises preceded by nontradable consumption booms are characterized by sharper real exchange rate depreciation and deeper economic contractions. We show that a small open economy model of Sudden Stops under non-homothetic preferences can rationalize the danger of credit-fueled nontradable booms. Nontradable goods are more income-elastic than tradable goods. Thus, when a credit boom leads to a Sudden Stop, the demand for nontradable goods contracts violently and proportionately more than under homothetic preferences, causing a larger depreciation that further decreases the collateral value amplifying the current account reversal by 24%. The amplified pecuniary externality calls for 15% more aggressive debt taxes and increases the welfare gains from simple rules.