Trend shocks and sudden stops

Abstract

Sudden Stops are characterized by large output drops, current account reversals and real exchange rate depreciation followed by a slow recovery, a pattern that has proven to be hard to capture with standard open economy models. This paper extends the standard models with endogenous collateral constraints to include permanent income (trend) shocks and studies the optimal policy design in this setting. We find that shocks to the trend play an important role in generating a Sudden Stop followed by a slow recovery, a result that is also supported by the data. With trend and transitory shocks, optimal capital control policy is procyclical, although less so than under transitory shocks only.