"Sudden Stops " experienced during emerging markets crises are characterized by large reversals of capital inflows and the current account, deep recessions, and collapses in asset prices. This paper proposes an open-economy equilibrium asset pricing model in which financial frictions cause Sudden Stops. Margin requirements impose a collateral constraint on foreign borrowing by domestic agents and trading costs distort asset trading by foreign securities firms. At equilibrium, margin constraints may or may not bind depending on portfolio decisions and equilibrium asset prices. If margin constraints do not bind, productivity shocks cause a moderate fall in consumption and a widening current account deficit. If debt is high relative to asset holdings, the same productivity shocks trigger margin calls forcing domestic agents to fire-sell equity to foreign traders. This sets off a Fisherian asset-price deflation and subsequent rounds of margin calls. A current account reversal and a collapse in consumption occur when equity sales cannot prevent a sharp rise in net foreign assets.
This paper investigates the optimal tax structure in an overlapping generations model in which individuals face idiosyncratic income risk, borrowing constraints and lifetime uncertainty. The calibrated model economy produces some quantitative results that differ significantly from the findings of the previous research. The main finding in this imperfect insurance setup is that moving away from capital income taxation toward higher labor income taxation yields a (steady-state) welfare benefit of 1% of aggregate consumption compared with the 6% figure Lucas (1990) finds in an infinite-horizon, complete markets model. This is because replacing the tax on capital income with a higher tax on labor income redistributes resources away from the young working years during which borrowing constraints are more likely to bind. Furthermore, when the individuals have access to a private annuity market to insure against uncertain lifetimes, it becomes optimal to tax capital. When a consumption tax is made available, it is optimal to switch to consumption taxation. The welfare benefit from implementing this optimal plan is on the order of 1.5-3.2% of GNP.
This paper is part of a project to model the interaction between heterogeneous agents in intertemporal stochastic models and to develop numerical algorithms to solve these kind of models. It is well-known that solving dynamic heterogeneous agent models is a challenging problem, since in these models the distribution of wealth and other characteristics evolve endogenously over time. Existing dynamic models in the literature contain therefore just two agents or other simplifying assumptions to limit the heterogeneity.