Antonio Fatas: Dealing with a sudden stop: Noted
Antonio Fatas: Dealing with a sudden stop:
A country with a current account deficit must have a matching capital inflow to finance the excess of spending above its income (this is an accounting identity). During the financial crisis many European countries faced a sudden stop.... It is not easy to use the IS-LM model to deal with sudden stops given that the IS-LM model is not the best model to analyze current account imbalances and situations where there is no price at which capital will fund a current account deficit.... To close a current account deficit you need to reduce imports. If there was a way to engineer a fall in imports, there would be no consequence to domestic demand and GDP. And if at the same time your currency is depreciating you could see an increase in exports and possibly in increase in activity. But there is no way to engineer a fall in imports....
When individuals of corporations who were borrowing abroad stop getting credit, there will be a fall in demand that will affect both domestic and imported goods. I am not saying anything new here, this is the way we teach about sudden stops and that's why we have mechanisms to provide liquidity during these times (e.g. lending by IMF) to ensure that the adjustment in the current account does not come in a very sudden way. There is no way to get out of this by inflation. Inflation can help dealing with monetizing internal debt (government debt) but cannot help smooth the consequences of sudden stop of capital that was financing a current account deficit. An exchange rate depreciation can help by increasing exports but this effect cannot be fast enough...
