_{1}

^{*}

This paper presents a simple modification to the standard IS curve used, at least implicitly, by policymakers that allows capital flight to have a contractionary effect in emerging market economies. In the standard model, capital flight leads to an expansionary shift in the IS curve through an increase in net exports. However, in the presence of liability dollarization for domestic firms, a currency depreciation triggered by capital flight leads to an investment collapse. A simple adjustment to the standard investment schedule captures this channel and allows for the possibility that capital flight yields a contractionary shift in the IS curve.

In the basic short run open economy model found in macroeconomics textbooks and used, at least implicitly, in policymaking, an episode of capital flight or a sudden stop of capital inflows is expansionary.1 The intuition is that the reduction in inflows and/or increase in outflows and the depreciation of the domestic currency stimulate net exports, which then increases output. While this result holds for advanced economies, it contradicts reality in the case of emerging market countries where sudden stops are usually contractionary.

The key feature of emerging economies that produces this different outcome is that their debt is often denominated in a foreign currency such as the dollar. The presence of liability dollarization implies that large depreciations can lead to significant reductions in net worth by inflating the domestic currency value of borrowers’ loans (De Nicoló, Honohan, Ize [

In fact, more recent research on the effects of exchange rate devaluations has placed greater emphasis on this financial or balance sheet channel than the traditional trade channel (c.f. Krugman [^{rd} generation currency crisis models in which financial factors play a primary role in the propagation of crises (Aghion, Bacchetta and Banerjee [

Bebczuk, Galindo and Panizza [

The result that capital flight is expansionary therefore contradicts both theoretical and empirical results for emerging market economies with liability dollarization. To bridge this gap, this paper presents a very simple modification of the standard IS curve that allows for the possibility of contractionary depreciations. The key insight is that a depreciation can lead to a decline in investment if firms suffer from liability dollarization and a decline in consumption if households have borrowed in dollars. Letting E represent the nominal exchange rate (foreign currency per domestic currency), then the investment function

captures the effect of the exchange rate on investment, in addition to the standard interest rate effect. In particular, a fall in E for a given r leads to a decline in investment. As mentioned above, this effect requires some imperfection in capital markets so that investment depends on net worth, as in the financial accelerator model. Similarly, the consumption function

allows the exchange rate to have independent effects on consumption through household balance sheets.

The rest of the model is standard. The determination of net exports is given by (c.f. Abel, Bernanke and Croushore [

or

“” includes the effect of government spending, taxes, and autonomous changes in consumption, investment, and net exports. Since a rise in r lowers investment and consumption, it is assumed that b_{1} > 0. The traditional assumption is that b_{2} > 0, assuming the Marshall-Lerner conditions are satisfied. However, in the presence of liability dollarization, the effect of a currency depreciation on household and firm balance sheets lowers consumption and investment. If this effect dominates the traditional trade effect so that, the depreciation results in a contractionary shift in the IS curve.

Substituting in a positive relationship between E and r (which can be derived, for example, from an interest rate parity condition) yields an open economy IS curve in which the coefficient of r incorporates the effects of E. Specifically, suppose the nominal exchange rate is given by, where “e” captures the sensitivity of the exchange rate to the domestic real interest rate and captures exogenous changes in the exchange rate. Substituting this relationship into equation (4) yields

or

Capital flight or sudden stops of capital inflows can be captured by a decrease in, which exogenously depreciates the exchange rate for a given real interest rate. Thus the effects of capital flight are given by

An episode of capital flight that causes an exogenous depreciation therefore leads to a fall in Y if the contractionary effects on consumption and investment, captured by, outweigh the expansionary effect on net exports, given by x.^{3} The former effects are likely to be large in countries with a high share of dollar liabilities, producing the observed result that sudden stops are contractionary in such economies. This characterization describes many of the emerging economies in East Asian, Latin America, and Eastern Europe. Graphically, the effect of capital flight on investment is captured by a leftward shift in the investment schedule (with r on the vertical axis), which acts to shift the IS curve left. Similarly, the effect on consumption is captured by a rightward shift in the savings line, which also shifts the IS curve to the left.

A contractionary shift in the IS curve then implies a similar shift in the aggregate demand curve. This is true if one is assuming monetary base targeting and an AD curve based on the IS-LM model or if one is assuming interest rate targeting and a Taylor rule to generate the AD curve (however, the size of the shift in the AD curve will depend on the particular model). Combined with an upward sloping AS curve, the end result is still a fall in output.

Liability Dollarization and the Potency of Monetary Policy The presence of liability dollarization also has implications for the slope of the IS curve and the potency of monetary policy. The effect of a change in interest rates on output is given by

The traditional effects of a change in the real interest rate on consumption, investment, and net exports are captured by. In particular, a fall in the real interest rate stimulates consumption and investment directly and depreciates the currency, thereby indirectly stimulating net exports.

However, in the presence of liability dollarization, lower interest rates induce a depreciation that lowers consumption and investment, captured by. These additional effects weaken the expansionary effect of lower interest rates.4 Graphically, the presence of liability dollarization steepens a downward sloping investment function by counteracting the stimulative effect of lower interest rates. This implies a steeper IS curve and a weaker effect of expansionary monetary policy. Similarly, liability dollarization makes consumption less sensitive to change in r. This steepens the savings line, which steepens the IS curve and again makes monetary policy less potent.

This paper presents a modification to the standard IS curve that captures the reality in most emerging market nations that sudden stops are contractionary events, and in many cases, highly contractionary. The key mechanism that produces this result is that when domestic firms or households have dollar liabilities on their balance sheets without corresponding dollar assets, exchange rate depreciations that occur during sudden stops can lead to large reductions in net worth. This can lead to higher borrowing costs and, in some cases, insolvency, both of which combine to reduce aggregate demand and output. Adding the exchange rate to the investment and consumption equation captures this channel. Depending on the extent of liability dollarization, the model can generate expansionary depreciations in more advanced economies with little liability dollarization or contractionary depreciations in those that suffer from significant liability dollarization.