Quantitative implications of a debt-deflation theory of Sudden Stops and asset prices

This paper shows that the quantitative predictions of an equilibrium asset-pricing model with financial frictions are consistent with key features of the Sudden Stop phenomenon. Foreign traders incur costs in trading assets with domestic agents, and a collateral constraint limits external debt to a fraction of the market value of domestic equity holdings. When this constraint does not bind, standard productivity shocks cause typical real-business-cycle effects. When it binds, the same shocks cause strikingly different effects depending on the leverage ratio and asset market liquidity. With high leverage and a liquid market, the shocks force “fire sales” of assets and Fisher's debt-deflation mechanism amplifies the responses of asset prices, consumption and the current account. Precautionary saving makes these Sudden Stops infrequent in the long run.