Robust policymaking in the face of sudden stops

This paper considers tax policies to deal with Sudden Stops – declines in aggregate activity that are magnified by a binding collateral constraint – that occasionally occur in emerging market economies. Households and/or the government are assumed to face model uncertainty and desire robustness against alternative models. Welfare gains from optimal taxation are small if the government trusts its model of household expectations, whether those expectations are altered by model uncertainty or not; in contrast, welfare losses are large if the government is uncertain about the household's probability model.

► Models with collateral constraints generate inefficient Sudden Stops. ► Optimal policy responses to these Sudden Stops depend on whether governments trust their model of household expectations. ► If governments trust the model, welfare gains from optimal taxation are small. ► If governments do not trust the model, welfare losses can be large.