Smoothing sudden stops

Abstract

Emerging economies are often exposed to sudden shortages of international financial resources. Yet domestic agents do not seem to take preventive measures against these sudden stops. We highlight the central role played by the limited development of ex ante (insurance) and ex post (spot) domestic financial markets in generating this collective undervaluation of international resources. We study several policies to counteract the external underinsurance. We do this by solving for the optimal mechanism given the constraints imposed by limited financial development, and then considering the main financial policies—in terms of the model and practical relevance—that implement this solution.