Exchange rate dynamics, balance sheet effects, and capital flows. A Minskyan model of emerging market boom-bust cycles

By Karsten Kohler

PKES Working Paper 1906

March 2019

The paper provides a dynamic Minskyan open economy model of endogenous boom-bust cycles in emerging market economies, which explains the empirically observed procyclicality of exchange rates and the countercyclicality of the trade balance. It highlights the interaction of exchange rate dynamics and balance sheets. Currency appreciation makes firm balance sheets with foreign currency debt more solid. Throughout the resulting boom phase, the current account position worsens. Pressures on the domestic exchange rate mount until the currency depreciates. Contractionary balance sheet effects then set in as domestic firms face a drop in their nominal net worth. If capital inflows are driven by exogenous risk appetite, these fluctuations can assume the form of shock-independent endogenous cycles. An exogenous increase in risk appetite increases the volatility of the cycle. We find that financial account regulation can help reduce macroeconomic volatility and that the larger the risk appetite, the more financial account regulation is required to achieve this.

Keywords: Business cycles, boom-bust cycles, emerging market economies, Minsky

JEL classification: E11 E12 F36 F41