Modeling International Capital Flows and Exchange Rates Movements

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The 1990s have witnessed both a dramatic expansion of capital flows into developing economies-the emerging markets boom-and an equally dramatic contraction of such flows following the 1994-1995 financial crisis in Mexico. The purpose of this research is to construct intertemporal general equilibrium models both for analyzing the capital flows that would follow financial opening in developing economies and for analyzing financial crises like that in Mexico. Although much of the proposed research focuses on the case of Mexico, it is applicable far more widely. This project will extend previous work by the author on modeling financial crises. It will generalize this work on self-fulfilling debt crises to allow for consumers who have risk-averse preferences and who would borrow and lend internationally. Preliminary results indicate that this extension will capture the capital flight that occurs when the probability of a debt crisis increased. The research will also develop an alternative, but related, model of self-fulfilling currency crises. The models of debt crises and those of currency crises will ultimately be linked through the crucial role that foreign reserves held by the government play in each model. A central feature of the proposed crises models is that they will be fully specified dynamic, stochastic general equilibrium models, as contrasted with the reduced form models found in the literature. In addition, a dynamic, stochastic general equilibrium model in which banking crises can occur in equilibrium will also be contracted and analyzed.