Topics in International Macroeconomics

Lecture 2: International Financial Crises and

Regulation of Capital Flows

Luca Fornaro

Fall 2021

1
 Motivation

During the last 30 years several countries have experienced

financial crises in which the international dimension played a
key role

2
DUHDYDLODEOHHSLVRGHVRUDERXWRQHLQWKUHHZHUHSUHFHGHGE\DFUHGLWERRP
Banking crises: 1970-2010
Figure 3. Banking Crises Cycles 1/
25

Great
Recession
20

Tequila
15 crisis

Transition
Asian
Economies
10 Crisis

Latin American
debt crisis
5

0
1970

1975

1980

1985

1990

1995

2000

2005

2010

Source: AXWKRUV¶FDOFXODWLRQV
1/ Number of systemic banking crises starting in a given year.
Source: Laeven and Valencia (2012)
 3
 Motivation

During the last 30 years several countries have experienced

financial crises in which the international dimension played a
key role

Each episode has its own peculiarities, but they all share some
common traits:

• The run-up to the crisis was characterized by large capital

inflows and accumulation of foreign debt, either by the
private or the public sector, sometimes by both.

• The crisis coincided with a sharp reduction in capital

inflows, a phenomenon dubbed sudden stop.

4
Spain - detrended GDP & Net exports/GDP

-5

-10
detrended GDP per capita
NX/GDP

1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

5
 percent  

0.0  
1.0  
2.0  
3.0  
4.0  
5.0  
6.0  
7.0  
8.0  
9.0  
10.0  

feb-­‐90  
gen-­‐91  
dic-­‐91  
nov-­‐92  
o8-­‐93  
set-­‐94  
ago-­‐95  
lug-­‐96  
giu-­‐97  
mag-­‐98  
apr-­‐99  
mar-­‐00  
feb-­‐01  
gen-­‐02  
dic-­‐02  
nov-­‐03  
o8-­‐04  
set-­‐05  
ago-­‐06  
lug-­‐07  
giu-­‐08  
mag-­‐09  
Spain - real interest rate

apr-­‐10  
mar-­‐11  
feb-­‐12  
gen-­‐13  
dic-­‐13  
nov-­‐14  
6
 Spain - house prices

House  price  
2200  

2000  

1800  
2005  euros/m2  

1600  

1400  

1200  

1000  

800  

7
Summary of sudden stop facts (Mendoza, AER 2010)

Empirically, a sudden stop is (most often) defined as an increase

in the current account-to-GDP ratio greater than one or two
standard deviations.

Sudden stops are rare events and represent a business cycle

asymmetry.

During a sudden stop:

• Capital inflows decrease and the current account increases.
• GDP, consumption and investment drop.
• Asset prices fall.
• Real exchange rate depreciates.

8
 Empirical responses to sudden stop
1942 THE AMERICAN ECONOMIC REVIEW DECEMBER 2010

Gross
  domestic
  product
  Private
  consumption

6.00 6.00

4.00 4.00

2.00 2.00
Percent

Percent
0.00 0.00

−2.00 −2.00

−4.00 −4.00

−6.00 −6.00
t−2 t−1 t t+1 t+2 t−2 t−1 t t+1 t+2

Investment Net exports–GDP

    ratio
 
3.00
20.00
15.00 2.00
10.00
1.00

Percent
5.00
Percent

0.00 0.00
−5.00 −1.00
−10.00
−2.00
−15.00
−20.00 −3.00
t−2 t−1 t t+1 t+2 t−2 t−1 t t+1 t+2

Tobin Q

1.050
Source: Mendoza (2010).
1.000

0.950 9
 −3.00
t−1
Empirical
t
response
t+1 t+2
of Tobin’s Q tot −sudden
2
stop
t−1 t

Tobin Q

1.050

1.000

0.950

0.900

0.850

0.800
t−2 t−1 t t+1 t+2

re 1. Macroeconomic Dynamics around Sudden Stop Events in Emerging Econ

Source: (cross-country
Mendoza (2010).medians of deviations
Note: Tobin’s Qfrom HPratio
is the trends)
of market
value of equity and debt outstanding over book value of equity.
fication of Sudden Stop events in the emerging markets data is taken from Calvo,10Iz
Empirical response of real exchange rate to sudden stop

Source: Korinek and Mendoza (Annual Review of Economics,

2014). Blue: full sample, purple: advanced economies, red:
developing countries 11
 Today’s plan

Domestic prices (for instance house prices) can play a key role
in determining the value of collateral and access to credit

We will explore the implications of this insight for open

economies

• Endogenous sudden stops (Mendoza 2002 and 2010)

• Multiple equilibria (Schmitt-Grohe and Uribe 2018)

• Welfare and regulation of capital flows (Bianchi 2011,

Korinek 2018)

12
Pecuniary externalities and macro-prudential policies

A recent literature has developed theories of optimal

macroprudential policies in presence of pecuniary externalities.

Microeconomic foundations: Lorenzoni (2008), Korinek (2010,

2011).

Quantitative analysis: Bianchi (2011), Bianchi and Mendoza

(2012), Benigno et al. (2011), Jeanne and Korinek (2010),
Fornaro (2012).

13
 Overborrowing and capital controls

Bianchi (2011) considers an open economy subject to the risk of

a sudden stop and evaluates the role of controls on capital
inflows.

Borrowing constraint based on income as in Mendoza (2002).

Capital controls are rationalized by the presence of a pecuniary

externality.

The basic insight is developed in Korinek (2011). Bianchi

(2011) provides a quantitative analysis.

14
 Model

Small open economy inhabited by continuum of mass 1 of

identical households.

Two consumption goods: tradable and non-tradable.

Households borrow from foreign investors at a fixed interest

rate r .

Every period households receive a stochastic endowment of

tradable and non-tradable goods.

Occasionally binding borrowing constraint.

15
 Households
Every period representative household chooses ctT , ctN and bt+1
to maximize expected utility:
∞
X
E0 β t u(ct )
t=0

 − 1
ct = ω(ctT )−η + (1 − ω)(ctN )−η η
Subject to budget constraint:

bt+1 + ctT + ptN ctN = ytT + bt (1 + r ) + ptN ytN

Borrowing constraint:

bt+1 ≥ −(κN ptN ytN + κT ytT )

16
 Sources of market incompleteness

The only financial asset available is a one period riskless bond

(no state-contingent bonds avaliable). This assumption is not
crucial for the inefficiency result (see Korinek, 2010).

Borrowing constraint based on income. Allows for differences in

collateral value of different sources of income → inefficiency
result depends crucially on κN > 0.

17
 Households’ optimality conditions
Optimal expenditure allocation between tradable and
non-tradable good:
  1+η
1−ω ctT
ptN =
ω ctN

Euler equation (optimal dynamic allocation of expenditure):

" #
∂u(ct ) ∂u(ct+1 )
= βEt (1 + r ) + µt
∂ctT T
∂ct+1

Complementary slackness condition on the borrowing

constraint:


µt bt+1 + (κN ptN ytN + κT ytT ) = 0

µ is the Lagrange multiplier on the borrowing constraint.

18
 Market clearing

Market clearing for the non-tradable good:

ctN = ytN

Market clearing for the tradable good:

bt+1 + ctT = ytT + bt (1 + r )

Aggregate borrowing constraint:

 1+η !
1−ω
N ctT
bt+1 ≥− κ ytN + κT ytT
ω ytN

19
 Constrained efficient allocation

Consider a social planner that is constrained by the aggregate

borrowing limit (hence reaching a constrained efficient
allocation).

The social planner chooses the level of debt of the economy, but
lets consumption markets clear competitively:
• Price of non-tradable good defined by the same rule as in
the competitive equilibrium.

20
 Constrained efficient allocation II
Every period planner chooses ctT , ctN and bt+1 to maximize:
∞
X
E0 β t u(ct )
t=0
 − η1
ct = ω(ctT )−η + (1 − ω)(ctN )−η
Subject to resource constraints:
ctN = ytN
bt+1 + ctT = ytT + bt (1 + r )
Borrowing constraint:
 
   
 N 1 − ω ctT 1+η N 
bt+1 
≥ − κ y + κ T T
y
yN t t 
 | ω {z t } 
ptN

21
 Constrained efficient allocation III

The Euler equation is the only optimality condition that differs

between the competitive equilibrium and the social planner
allocation:
" #
∂u(ct ) ∂u(ct+1 )
= β(1 + r )Et + ψt+1 µSP SP
t+1 + µt (1 − ψt )
∂ctT T
∂ct+1
 η
∂ptN N
N 1−ω ctT
ψt ≡ κ T
yt = κN (1 + η)
∂ct ω ytN
The variable ψ > 0 captures the impact of changes in
consumption of tradables on p N .

22
 Constrained efficient allocation IV

To gain intuition assume that the borrowing constraint does not

bind (µSP
t = 0):
" #
∂u(ct ) ∂u(ct+1 ) SP
= β(1 + r )Et + ψt+1 µt+1
∂ctT T
∂ct+1

If the borrowing constraint is expected to bind with positive

probability in the future the social planner saves more (i.e.
chooses a higher bt+1 ) compared to the competitive equilibrium.

→ rationale for policies that increase incentives to save, such as

macroprudential policies.

23
 Decentralization of social planner allocation
The social planner allocation can be decentralized with a tax on
borrowing τ :
" #
∂u(ct ) ∂u(ct+1 )
= β(1 + τt )Et (1 + r ) + µt
∂ctT T
∂ct+1

When µSP
t does not bind the tax must be set to:

Et µSP
t+1 ψt+1
τt = T
≥0
Et ∂u(ct+1 )/∂ct+1

When µSPt = 0 the tax has no impact on borrowing and can be

set to any value (we will set it to zero).

This tax can be interpreted as a macroprudential tax or capital

controls (since all the borrowing comes from foreign investors).

24
 Decentralization of social planner allocation II

There are other policies that can implement the social planner
allocation.

One possibility is to introduce margin requirements θ, so that:

bt+1 ≥ −(1 − θt )(κN ptN ytN + κT ytT )

The social planner allocation is decentralized by setting:

SP
bt+1
θt = 1 −
(κN ptN ytN + κT ytT )
SP is the optimal amount of borrowing in the social
where bt+1
planner allocation.

25
 Quantitative analysis

Bianchi (2011) also studies the quantitative properties of the

optimal policy.

Model solved using a global method.

The model is calibrated to Argentina (1965-2007).

Objectives:
• Show that model generates business cycles broadly
consistent with Argentina’s experience.
• Illustrate how optimal tax affects business cycle
fluctuations.
• Compute welfare gains from optimal tax.

26
 The standard deviations of tradable and nontradable output in the data are
Calibration
σyT = 0.058 and σyN = 0.057, the first-order autocorrelations are ρyT = 0.53
and ρyN = 0.61, and the correlation between the two is ρyT ,yN = 0.81. Thus
cyclical fluctuations in the two sectors have similar volatility and persistence,
and are positively correlated with each other. We discretize the vector of shocks
into a first-order Markov process, with four grid points for each shock, using the
quadrature-based procedure of George Tauchen and Robert Hussey (1991). The
mean of the endowments are set to one without loss of generality.

Table 1—Calibration

Value Source/Target
Interest rate r = 0.04 Standard value DSGE-SOE
Risk aversion σ=2 Standard value DSGE-SOE
Elasticity of substitution 1/(1 + η) = 0.83 Conservative value
Stochastic structure See text Argentina’s economy
Relative credit coefficients κN /κT = 1 Baseline Value
Weight on tradables in CES ω = 0.31 Share of tradable output=32%
Discount factor β = 0.91 Average NFA-GDP ratio = −29%
Credit coefficient κT = 0.32 Frequency of crisis = 5.5%

The intratemporal elasticity of substitution 1/(η + 1) is a crucial parameter

because it affects the magnitudes of the price adjustment. For a given reduction
in tradable consumption, a higher elasticity implies a smaller change in the price of
nontradables, and therefore we should expect weaker effects from the externality.
The range of estimates for the elasticity of substitution is between 0.40 and 0.83.9
As a conservative benchmark, we set η such that the elasticity of substitution
equals the upper bound of this range and then show how the externality changes
with this parameter.
27
The ratio κN /κT determines the relative quality of nontradable and tradable
 Calibration II
The processes for y T and y N are chosen to replicate the
volatility and persistence of Argentina’s GDP (however,
Argentina has a very volatile business cycle, so it is not
representative of other countries).

Note that β(1 + r ) < 1:

• In a non-stochastic model this condition implies that the

borrowing limit binds in steady state.

• With uncertainty the borrowing limit is only occasionally

binding because of precautionary savings. There is a well
defined ergodic distribution of bond holdings.

If instead β(1 + r ) ≥ 0 assets would go to infinity in the long

run (Ljiungqvist and Sargent chapter 16).

28
VOL. VOL NO. ISSUE BIANCHI: OVERBORROWING AND SYSTEMIC EXTERNALITIES 15 Policy functions
−0.6

−0.7
Next Periodt Bond Holdings

−0.8
Constrained Region

Social Planner

−0.9

Decentralized Equilibrium

−1
Tax Region No−Tax Region

−1 −0.9 −0.8 −0.7 −0.6

Current Bond Holdings

Figure 1. Bond decision rules for negative one-standard-deviation shocks

29
credit constraint. Comparing the policy functions against the 45-degree line also
of debt than the maximum held by the social planner, illustrated by the shaded
region in Figure 2.
Ergodic distribution of bond holdings
−3
x 10
1.05

0.7
Probability

0.35 Social Planner

Decentralized Equilibrium

0
−1 −0.95 −0.9 −0.85 −0.8 −0.75 −0.7
Bond Holdings

Figure 2. Ergodic Distribution of Bond Holdings

30
Notice that the large differences in the left tail distribution of debt are not
 Optimal taxTax
Implied onon
debt
Debt
25 40

35
20
30

25
Percentage

Percentage
15

20

10
15

10
5
5

0 0
−1 −0.9 −0.8 −0.7 −0.6
Current Bond Holdings
31
Figure 3. Policy Instruments for negative o
 Optimal policy

Social planner saves more compared to the competitive

equilibrium (hence it looks like atomistic agents overborrow).

As debt increases also the distance between the two allocations

increases because the probability of being constrained in the
future rises.

Optimal tax depends on the state of the economy and increases

with debt.

Average tax is 3.6 percent.

32
decentralized equilibrium are much more likely: the long-run probability of crises
is 5.5 percent (versus 0.4 percent for the social planner). Thus, by reducing the
Ergodic distribution of consumption
amount of debt, the social planner cuts the long-run probability of a financial
crisis more than tenfold.
−3
x 10
4

3.5

3 Social Planner

2.5
Probability

1.5
Decentralized Equilibrium

0.5

0
−40 −35 −30 −25 −20 −15 −10 −5 0 5
Percentage change in consumption

Figure 4. Conditional distribution of impact effect of financial crises on consumption

Second, the magnitudes of financial crises are substantially more severe because
of the externality. Figure 4 shows the distribution of the response of the consump- 33
tion basket on impact during financial crises for the two equilibria, expressed as
the current account does not increase (versus an 8 percent increase in the decen-
Severity
tralized equilibrium), and the realof financial
exchange crises 1 percent (versus 19
rate depreciates
percent in the decentralized equilibrium).13 Notice that since the initial level of
debt and the sequence of shocks are the same for the two equilibria, the differ-
ence in the impact of crises is entirely due to the more prudent behavior of the
social planner during the periods preceding the crisis, which makes the required
adjustment following an adverse shock less severe.

Table 2—Severity of Financial Crises

Decentralized Equilibrium Social Planner

Consumption -16.7 -10.1
Current Account-GDP 7.8 0.0
Real exchange rate depreciation 19.2 1.1
Note: Consumption and real exchange rate depreciation represent responses on im-
pact expressed as percentage deviations from averages in the corresponding ergodic
distribution.

E. Second Moments

Table 3 compares the unconditional second moments for decentralized and

constrained-efficient equilibria, which are computed using each economy’s ergodic
distribution, and for the Argentinian data. It is apparent that the externality
produces non-trivial effects on the volatility of consumption, capital flows, and
especially the real exchange rate. Two reasons for this are that, first, the economy 34
 Business cycle moments
20 THE AMERICAN ECONOMIC REVIEW MONTH YEAR

Table 3—Second Moments

Decentralized Social
Equilibrium Planner Data
Standard Deviations
Consumption 5.9 5.3 6.2
Real Exchange Rate 7.5 3.4 8.2
Current Account-GDP 2.8 0.6 3.6
Trade Balance-GDP 2.9 0.6 2.4

Correlation with GDP in units of tradables

Consumption 0.83 0.86 0.88
Real Exchange Rate 0.79 0.44 0.41
Current Account-GDP -0.76 -0.05 -0.63
Trade Balance-GDP -0.77 -0.16 -0.84

Note: Data is annual from WDI for Argentina from 1965-2007. The real exchange
� � �η/(1+η) �−(1+η)/η
rate is calculated as ω 1/(1+η) + (1 − ω)1/(1+η) pN and is measured
empirically using value added deflators.

Table 3 also shows that the model accounts reasonably well for observed busi-
ness cycle moments for Argentina, in line with previous studies. Moreover, it is
apparent that the externality is important in accounting for two key regularities
in the emerging market business cycle: the high volatility of consumption and 35
cost of business cycles is typically small. Even if the planner does not introduce
additional securities that partially complete the market, welfare gains are still
Welfare gains
larger than the benefits from introducing asset price guarantees (Mendoza and
Bora Durdu, 2006) or the benefits from introducing indexed bonds (Durdu, 2009),
often suggested as policies to address Sudden Stops (Caballero, 2002).

0.2

Percentage of Permanent Consumption

0.15

0.1

0.05
−1 −0.9 −0.8 −0.7 −0.6
Current Bond Holdings

Figure 5. Welfare gains from correcting externality for negative one-standard-deviation

shocks

We see these welfare gains of correcting the externality as a lower bound. First,
the supply side of the economy is the same for both equilibria. If financial crises
distort the efficient use of production resources, correcting the externality could
deliver higher welfare gains. Second, the risk we have considered is only aggregate; 36
count factor and the interest rate, because these parameters affect the household’s
impatience and its willingness to borrow.
Sensitivity
(A) Elasticity of Substitution (B) Share of Nontradables in GDP
6 0.25 6

5 0.2 5 0.5

4 4
0.15
3 3
0.1 0.25
2 2

1 0.05 1

0 0 0 0
0 5 10 15 20 0.55 0.6 0.65 0.7 0.75

(C) Collateral Coefficient (D) Relative Quality of Nontradable Collateral (c)

6 0.3 6 0.16

5 5
0.12
4 0.2 4

3 3 0.08

2 0.1 2
0.04
1 1

0 0 0 0
0.3 0.35 0.4 1 0.8 0.6 0.4

Average Tax (left axis) Welfare(right axis)

Figure 6. Sensitivity Analysis: Welfare and Implied Tax (in Percentage)

37
 Impact of optimal policy

Optimal policy has a significant impact on behavior of the

economy during crises and on business cycle fluctuations.

Average welfare gains are small (equivalent to a 0.135 percent

permanent increase in consumption).

38
Macroprudential policies with collateral constraints
based on asset prices

Jeanne and Korinek (2010) and Bianchi and Mendoza (2010)

study macroprudential policies in endowment economies subject
to collateral constraints based on asset prices (as in Mendoza,
2010).

Overall, the results are similar to Bianchi (2011).

However, the problem is more complicated and time-consistency

issues can arise.

39
Crisis event (Bianchi and Mendoza, 2010)
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Figure 6: Event Analysis: percentage differences relative to unconditional averages

To gain more intuition on why asset prices drop more because of the credit externality, we
plot in Figure 7 the projected conditional sequences of future dividends and asset returns up
40
to 30 periods ahead of a financial crisis that occurs at date t = 0 (conditional on information
 Appendix: international financial crises
• Latin American debt crisis (early 1980s): Latin
American governments had borrowed heavily from foreign
banks. Crisis started when, following negative terms of
trade shocks and the rise of US interest rates during
Volcker’s disinflation, foreign banks decided not to roll over
existing loans.
• Scandinavian crisis (late 1980s): Financial
liberalization induced domestic banks to borrow from
abroad, contributing to a rise in credit and the emergence
of a housing bubble. The crisis coincided with the burst of
the bubble and a stop in foreign lending.
• Tequila crisis (Mexico 1994-95): The run-up to the
crisis was characterized by large current account deficits,
government had taken substantial foreign debt. Crisis
started when foreign investors stopped rolling over
government debt.
41
Appendix: International financial crises (cont’d)

• Asian crisis (1997): Large foreign borrowing by banks

and firms fueled an investment boom and a housing bubble.
Crisis coincided with a sharp decrease in foreign lending.

• Argentina (2001): Both government and private sector

had borrowed heavily from abroad. Key component of the
crisis was progressive loss of access to foreign financing.

• Eurozone crisis (2008-ongoing): After joining the Euro

peripheral countries accumulated large amounts of foreign
debt. After the 2008 global financial crisis, foreign
financing dried up.

42