Lending Booms, Sharp Reversals and Real Exchange Rate Dynamics

Emerging market economies in the nineteen nineties have experienced periods of booms followed by collapses in gross domestic product, consumption, traded and nontraded sector output and real exchange rate movements alongside unprecedented movements in foreign investor participation in these economies. An important feature of these episodes is the asymmetry in the pattern of booms and collapses. We introduce a natural search friction into the foreign investment decision in a small open economy and demonstrate that this can generate both the gradual appreciations in the real exchange rate and growth in production during expansions and the asymmetrically sharp downward adjustment during contractions. The magnitude of the reversals predicted by the model can be quantitatively large and empirically relevant. The adjustment hazard model of investment we present generates predictions that differ qualitatively from the standard quadratic adjustment cost model of investment. ∗I am especially thankful to Mark Aguiar, Ben Bernanke, Ariel Burstein, Steve Davis, Pierre-Olivier Gourinchas, Amartya Lahiri, Wojciech Olszewski, Assaf Razin, Kenneth Rogoff, Alwyn Young and two anonymous referees for their advice on this paper. I also wish to thank seminar participants at Cornell University, Delhi School of Economics, NBER International Finance summer meetings, Society of Economic Dynamics meetings, University of Washington, Wharton School of Business and University of Wisconsin for comments. All remaining errors are my own. email: [email protected]. Tel: (773)7029297. Fax: (773)7020458