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Interest Premium, Sudden Stop, and Adjustment in a Small Open Economy

Author

Listed:
  • Peter Benczur

    (Institute of Economics, Centre for Economic and Regional Studies, Hungarian Academy of Sciences and European Commission, Joint Research Centre (JRC) Central European University)

  • Istvan Konya

    (Institute of Economics Centre for Economic and Regional Studies, Hungarian Academy of Sciences and Central European University)

Abstract
We study the adjustment process of a small open economy to a sudden worsening of external conditions. To model the sudden stop, we use a highly non-linear specification that captures credit constraints in a convenient way. The advantage of our approach is that the effects of the shock become highly conditional on the external debt position of the economy. We adopt a two-sector model with money-in-the-utility, which allows us to study sectoral asymmetries in the adjustment process, and also the role of currency mismatch. We calibrate the model to the behavior of the Hungarian economy in the 2000s and its crisis experience in 2008-11 in particular. We also calculate four counterfactuals: two with different exchange rate policies (a more flexible float and a perfect peg), and then these two policy regimes with smaller initial indebtedness. Overall, our model is able to fit movements of key aggregate and sectoral macroeconomic variables after the crisis by producing a large and protracted deleveraging process. It also offers a meaningful quantification of the policy tradeoff between facilitating the real adjustment by letting the currency depreciate and protecting consumption expenditures by limiting the adverse effect of exchange rate movements on household balance sheets.

Suggested Citation

  • Peter Benczur & Istvan Konya, 2015. "Interest Premium, Sudden Stop, and Adjustment in a Small Open Economy," CERS-IE WORKING PAPERS 1505, Institute of Economics, Centre for Economic and Regional Studies.
    • Handle: RePEc:has:discpr:1505
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    References listed on IDEAS

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    1. Charlotta Groth & Hashmat Khan, 2010. "Investment Adjustment Costs: An Empirical Assessment," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(8), pages 1469-1494, December.
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    Cited by:

    1. Mavrigiannakis, Konstantinos & Sakkas, Stelios, 2024. "EU sanctions on Russia and implications for a small open economy: the case of Cyprus," LSE Research Online Documents on Economics 125336, London School of Economics and Political Science, LSE Library.
    2. Konstantinos Mavrigiannakis & Stelios Sakkas, 2024. "EU sanctions on Russia and implications for a small open economy: The case of Cyprus," GreeSE – Hellenic Observatory Papers on Greece and Southeast Europe 200, Hellenic Observatory, LSE.
    3. Kónya, István & Váry, Miklós, 2024. "Which sectors go on when there is a sudden stop? An empirical analysis," Journal of International Money and Finance, Elsevier, vol. 146(C).
    4. Brzoza-Brzezina, Michał & Kotłowski, Jacek, 2020. "The Nonlinear Nature Of Country Risk And Its Implications For Dsge Models," Macroeconomic Dynamics, Cambridge University Press, vol. 24(3), pages 601-628, April.

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    More about this item

    Keywords

    interest premium; sudden stop; small open economy;
    All these keywords.

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E41 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Demand for Money
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • F3 - International Economics - - International Finance

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