Credit-Market Frictions, Policy-Credibility and the Business Cycle of Emerging Markets

This version: November 8, 1999
Preliminary and incomplete,
not for circulation without author’s consent
Credit-Market Frictions, Policy-Credibility and the Business Cycle of Emerging Markets*
by
Enrique G. Mendoza
Duke University and NBER
Department of Economics
Box 90097
Duke University
Durham, NC 27708-0097
This paper examines the interaction between credit-market frictions and lack of
credibility of government policy in determining the transmission mechanism of business
cycles in emerging markets. Two variants of an equilibrium business-cycle model with
credit-market frictions are explored: a case of a managed exchange-rate regime in which
households face a liquidity constraint that limits foreign debt to a fraction of their
current income and liquid-asset holdings, and a case of an economic reform undertaken
in an economy where households face a margin constraint limiting foreign debt to a
fraction of their equity purchases (and in which equity is traded with foreign securities
firms that face portfolio adjustment costs). These contribute to magnify the adverse real
effects by which lack of policy credibility induces larger and more costly business cycles
in emerging markets. Strategies for addressing the severe credibility problems facing
policymakers in emerging markets are strongly favored by these findings.
*Helpful comments and suggestions by Guillermo Calvo, Alfonso Guerra, Urban
Jermann, Vincenzo Quadrini and Bernardo Paasche are gratefully acknowledeged. Part of this
work was done while the author was a visiting scholar at the Economic Studies Division of the
Bank of Mexico. Comments and suggestions by its staff members are also gratefully
acknowledged. The paper reflects only the author’s views, and not those of the Bank of Mexico
or members of its staff.

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1.
Introduction
The recent period of intense turbulence in international financial markets has been
marked by the collapse of several managed exchange-rate regimes (including those of Brazil,
Chile, Colombia, Ecuador, Korea, Indonesia, Malaysia, Mexico, Russia, and Thailand) and by
severe speculative attacks on other currencies that were not devalued (such as those of Argentina,
Hong Kong and Taiwan). This epidemic of financial crises, and the severity of the economic
recessions that followed each of them, has re-opened the protracted debate on the optimal choice
of exchange-rate regime with a new sense of urgency. For the most part, this new stage of the
debate has been dominated by revisions of Mundell’s (1961) classic arguments establishing
conditions under which a fixed exchange rate, a flexible exchange rate or a currency union
constitute the optimal exchange-rate regime from the perspective of each regime’s ability to
smooth macroeconomic adjustment.
The classic Mundellian approach to assess exchange-rate regimes has provided very
important insights in the past, but there are at least two reasons to be less optimistic about its
usefulness in the case of the recent emerging-markets crises and the ongoing policy debate on
exchange-rate regimes. One reason is that the Mundellian approach abstracts from the financial
frictions that have played a key role in recent crises, and hence it does not provide policymakers
with a clear understanding of how, or even whether, alternative exchange-rate regimes can help
address those frictions and thus prevent future crises. The second reason is that the Mundellian
approach conceives the choice of exchange-rate regime as if it were made in a vacuum, where
any regime can be chosen at will and maintained in place indefinitely. The Mundell-Fleming
apparatus is set to work under alternative exchange-rate regimes, and the “winner” is the regime
that yields smaller income fluctuations for a given environment of trade integration, factor
mobility, and exogenous shocks. In contrast, issues related to the sustainability of a particular

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exchange-rate regime once adopted, to the transition from one regime to another, or to the
distortions that result from the credibility problems faced by policy-makers under alternative
regimes are among the major issues that emerging economies are dealing with.1 This paper aims
to contribute to the policy debate on exchange-rate regimes by incorporating some of these
issues into a framework in which their implications for macroeconomic fluctuations and social
welfare can be assessed.
The paper focuses in particular on two issues emphasized by the severe financial crises
and deep economic recessions that swept through emerging markets recently: the role of
financial-market frictions in accounting for the large amplitude of business cycles in emerging
economies, in particular the sharp recessions observed after currency crashes, and the interaction
between policy-credibility problems and these financial-market frictions. The paper aims to
assess the significance of the business cycle transmission mechanism that results from this
interaction, and to explore its effects on social welfare.
The observation that financial factors and policy-credibility problems were a primary
cause of recent emerging-markets crises has been a central element of the recent literature
studying these crises. Several studies have explored theoretical and empirical aspects of issues
such as the connection between banking fragility and speculative attacks, self-fulfilling crises
inducing runs on public debt, the role of liquidity-generating bonds, and the phenomenon of
financial contagion resulting from informational frictions (see the November 1996 and 1991
symposium issues of the Journal of International Economics for a short sample of the work in
1It is paradoxical that while Mundell himself recognized that these issues were critical for
the optimal choice of exchange-rate regime (see, for example, his analysis of business cycles
driven by currency speculation in Mundell (1960)), most of the literature that followed his 1961
article generally abstracted from them.

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this area). The emphasis that this literature places on the financial sector in the analysis of
currency crises contrasts sharply with traditional theories that attribute currency crises to the
trade implications of overvalued real exchange rates or to the monetization of fiscal deficits.
This paper intends to contribute to the literature by developing a manageable business-cycle
model that captures the link between the credibility of the exchange-rate regime, financial-market
frictions, and the real economy, and thus provides a framework for re-examining arguments in
favor or against alternative exchange-rate regimes.
The analysis of the policy-credibility tradeoffs associated with exchange-rate regimes is
the focus of a large research program on the study of stabilization programs anchored on
managed exchange rates initiated by the work of Calvo (1986), Helpman and Razin (1987), and
Drazen and Helpman (1987). This research program showed that lack of policy credibility can
be the source of important distortions on the real sector of the economy that may contribute to the
severity of financial crises and recessions that accompany devaluations. However, the analysis of
the connection between economic policies that lack credibility, financial-market frictions, and
economic fluctuations in emerging economies is still unchartered territory (some new insights on
this matter have emerged in recent work by Calvo (1999) and in a series of studies on the role of
credit-market frictions in recent crises based on the influential closed-economy model of
Kiyotaki and Moore (1997)) .1
This paper develops two variants of a basic dynamic general equilibrium framework in
which financial-market frictions interact with economic policies that lack credibility in driving
the business cycles of a small open economy. Economic policies are modeled to be non-credible
1These studies include Edisson, ... and Miller (1997), Paasche (1999), Tornell and
Schneider (1999), and Caballero and Krishnamurty (1999).

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in the sense that private agents attach an exogenous probability to the reversal of an announced
policy stance. The two variants of the model highlight alternative financial frictions and policy
experiments. First, a non-credible exchange-rate-based stabilization plan that is implemented in
an economy in which a liquidity requirement limits foreign borrowing by households to a
fraction of their current income and liquid asset holdings. Second, a non-credible economic
reform (i.e., a cut in distortionary taxes or tariffs) introduced in an economy in which domestic
households and foreign securities firms trade equity, but the former face a margin requirement
limiting their ability to leverage equity holdings and the latter face a cost of adjustment in
altering their equity portfolio.
In the absence of credit frictions, the two policy experiments mentioned above are very
similar. In fact, the monetary distortions that drive exchange-rate-based-stabilization models are
identical to changes in ad-valorem consumption taxes (see Mendoza and Uribe (1999a)). In this
paper, however, the introduction of financial frictions complicates the analysis in a manner such
that lack of credibility in the presence of a margin requirement is significantly more tractable in
a non-monetary economy. This is because the margin-requirement experiment needs a tractable
specification for studying the equilibrium dynamics of the forward-looking equity price that
determines the margin constraint. The analysis of collateral constraints by Kiyotaki and Moore
(1997) and the study of margin requirements by Aiyagari and Gertler (1999) also focus on non-
monetary economies for simplicity.2
The margin requirement and the liquidity constraint are defined in terms of the value of
the households’ asset holdings or income, and hence whether they are binding or not is an
2Cooley and Quadrini (1997) and Bernanke and Gertler (1995) explore closed-economy
monetary models with credit-market frictions.

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endogenous outcome of the cyclical dynamics of the economy. They may not be binding in
“good” states of nature but they can become binding in “sufficiently bad” states of nature (i.e.,
they represent what is referred to as an “occasionally-binding constraint”). Frictions like these
introduce an important form of market incompleteness that can have major implications for
equilibrium prices and allocations because they produce dynamics driven by Fisher’s (1933)
“financial accelerator,” by which the impact of an initial shock is greatly magnified through its
effect on current asset prices and the future user’s cost of those assets.
The analysis conducted in the paper yields some illustrative analytical results and
produces a series of numerical simulations. The latter are useful to explore the qualitative and
quantitative features of the model’s dynamics in the presence of the “occasionally-binding” credit
frictions, which in general cannot be established analytically. The quantitative experiments have
other useful applications. First, they are helpful in assessing to what extent the Fisherian
multipliers contribute to explain the empirical regularities of exchange-rate-based stabilizations
beyond the fraction that can be accounted for by devaluation risk in the absence of financial
frictions. Second, they provide a means for exploring the implications of different shocks that
can trigger the Fisherian multipliers (i.e., devaluations, large shocks to productivity or the terms
of trade, and “liquidity” shocks to the world interest rate). Third, they provide a framework for
examining the normative aspects of the model and its policy implications. In particular, the
welfare effects of financial frictions under an “imperfectly credible” fixed exchange-rate regime
can be quantified and compared against those that would operate under a full currency union (or
“perfectly credible” currency peg).
Credit-market frictions have the technical drawback that they increase the complexity of
methods used to solve for competitive equilibria (see Aiyagari and Gertler (1999)), thereby

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making it difficult for researchers to incorporate these frictions into the widely-used quantitative
framework of modern business cycle theory. Most of the existing research has focused on
environments in which these frictions are either always binding (as in Kiyotaki and Moore (1997)
or Bernanke, Gertler and Girlchrist (1998)) or occasionally binding in the short run but never
binding at steady state (as in Aiyagari and Gertler (1999)). In contrast, the framework proposed
in this paper is sufficiently tractable to yield numerical solutions for the business-cycle dynamics
of a small open economy in which credit frictions can be binding or nonbinding in the short run
and in the long run. This is due mainly to the model’s specification of preferences which allows
for the subjective rate of time preference to be endogenously determined.
In the first variant of the model examined in this paper, the liquidity requirement and the
exchange-rate-based stabilization plan interact as follows. Assume the government introduces a
managed exchange rate as a part of a stabilization plan to reduce inflation from very high levels,
as was the case in Mexico in 1987. It is well-known that this kind of stabilization plan produces
a sharp appreciation of the real exchange rate, large booms in output and absorption, a marked
worsening of the external accounts, and a surge in the demand for money. Mendoza and Uribe
(1999a) showed that an equilibrium business cycle model, in which the risk of devaluation is the
driving force of business cycles, can account for a nontrivial fraction of the magnitude of these
observed empirical regularities. In that model, however, the economy could borrow at the given
world real interest rate as much as it could afford subject only to the standard no-Ponzi-game
restriction. In contrast, the liquidity requirement forces households to finance a fraction of their
current expenditures out of current income and holdings of liquid assets (i.e., real money
balances). This translates into a constraint limiting foreign debt not to exceed a certain fraction
of the sum of domestic income plus the real value of money balances.

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As the country enters into the exchange-rate-based stabilization, the associated economic
expansion, real appreciation and surge in money demand may induce an endogenous relaxation
of the borrowing limit (if the limit was binding initially), hence providing a channel for
magnifying the real effects of the stabilization plan. Similarly, when the exchange rate collapses,
the negative policy shock may tighten the borrowing limit to the point of making it binding, thus
providing a mechanism for magnifying the recessive effects of a currency crash.
In addition to the direct effects of income and money-demand fluctuations on the
tightness of the borrowing constraint, the paper shows that the presence of the constraint may
magnify the credibility distortions associated with the probability of collapse of a fixed exchange
rate. This occurs because the effective intertemporal relative price of consumption facing the
small open economy rises in states of nature in which the constraint is binding. As a result, the
economy’s opportunity cost of holding money rises, and the monetary distortion reflected in
changes in the marginal costs of transactions (which is itself an increasing function of the
opportunity cost of holding money) also increases. Moreover, the model features an endogenous
channel for making the effects of a binding liquidity requirement persistent. This is because the
increase in the opportunity cost of holding money (induced by a suddenly-binding liquidity
constraint in the current period) leads to a fall in money demand, and this in turn implies that
holdings of liquid assets in the next period are reduced, making it more likely that the constraint
will continue to bind.
If the business-cycle implications of the interaction of the liquidity requirement with the
lack of credibility of the currency peg are important, the arguments in favor of strategies aimed at
addressing the lack of credibility of exchange-rate policy are strengthened. For example, a
currency union (or a fully-credible regime of “dollarization” of the financial system) would

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virtually eliminate the risk of devaluation, and in doing so it would do away with both the basic
distortions on relative prices that result from devaluation risk as well as with the harmful
multiplier effects on those distortions resulting from the Fisherian accelerator. Note, however,
that if the borrowing limits were binding at the moment the currency union were introduced, the
multipliers at work during the economic expansion that would follow would still operate. Hence,
the main advantage of the currency union would be in that it would avoid the effects of the
negative multipliers at work when the currency collapses.
The second credit-market friction examined in the paper differs from the liquidity
requirement because it focuses on the role of asset-price fluctuations when households face a
margin requirement in its use of foreign debt to leverage domestic equity positions. The margin
requirement thus limits foreign borrowing not to exceed the value of equity purchases by a given
margin (i.e., it is a constraint driven by the value of the stock of capital owned by households
rather than by the value of their income flow). The assumption that the small open economy
trades equity with global securities firms that face a portfolio adjustment cost in entering the
domestic equity market yields a nontrivial determination of the equilibrium equity price. In
particular, if the margin requirement binds, the price of equity deviates from its “fundamentals”
level and the deviations have persistent effects. Moreover, it is shown that the expectation of
the margin requirement becoming binding in the future is sufficient to make the current equity
price deviate from its “fundamentals” value.
The model of the the margin-constrained economy can be used to study how the economy
responds to a non-credible economic reform. The reform in question could be the elimination of
a uniform consumption tax or tariff, the reversal of which is assigned an exogenous positive
probability by domestic agents. If the reversal were to make the margin requirement suddenly

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binding, domestic agents would seek to cut back their equity holdings but they will only be able
to do it by selling at a price below the fundamentals level to the foreign securities firms. This
will in turn tighten further the borrowing constraint and magnify the real effects of the policy
shock. This process resembles again elements of the deflationary spirals described by Fisher
(1933), and modeled in the closed-economy studies of Kiyotaki and Moore (1997), Aiyagari and
Gertler (1999), and Bernanke, Gertler and Grilchrist (1998). Calvo (1999) incorporated recently
this issue into the analysis of contagion of currency crises.
The paper proceeds as follows. Section 2 develops the model of exchange-rate
management in the presence of liquidity requirements. Sections 3 proposes the model of
international equity trading under margin requirements. Section 4 conducts a numerical-
simulation analysis of the exchange rate model based on a calibration of the model applied to the
Mexican 1987-1994 stabilization plan. Section 5 concludes and draws policy lessons.
2. Liquidity Requirements and Business Cycles in a Small Open Economy
The framework developed in this paper represents a small open economy inhabited by a
large number of identical, infinitely-lived households that formulate optimal intertemporal plans
with regard to labor supply and consumption. Preferences are represented with a particular utility
function that allows the model to support stationary equilibria in which credit-market frictions
may or may not bind, as well as off-steady-state dynamics in which the frictions may switch from
non-binding to binding. The utility function is Epstein’s (1983) version of time-recursive
expected utility with an endogenous rate of time preference. Preferences of this kind have been
used before in models of the small open economy with difference purposes: namely, to address
the problems of steady-state dependency on initial conditions and state-contingent wealth
distributions that are typical of these models (see Obstfeld (1981) and Mendoza (1991)).

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