Financial Crises in Emerging Markets: A Canonical Model

Roberto Chang and Andrés Velasco
Federal Reserve Bank of Atlanta
Working Paper 98-10
July 1998

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We present a simple model that can account for the main features of recent financial crises in emerging markets. The international illiquidity of the domestic financial system is at the center of the problem. Illiquid banks are a necessary and a sufficient condition for financial crises to occur. Domestic financial liberalization and capital flows from abroad (especially if short-term) can aggravate the illiquidity of banks and increase their vulnerability to exogenous shocks and shifts in expectations. A bank collapse multiplies the harmful effects of an initial shock, as a credit squeeze and costly liquidation of investment projects cause real output drops and collapses in asset prices. Under fixed exchange rates, a run on banks becomes a run on the currency if the central bank attempts to act as a lender of last resort.

JEL classification: F3, E5, G2

Key words: crises, financial systems, exchange rate systems, liquidity

Velasco acknowledges generous support from the C.V. Starr Center for Applied Economics at New York University and from the Harvard Institute for International Development. The views expressed here are those of the authors and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.

Please address questions regarding content to Roberto Chang, Research Officer, Research Department, Federal Reserve Bank of Atlanta, 104 Marietta Street, NW, Atlanta, Georgia 30303-2713, 404/498-8057,; or Andrés Velasco, Professor of Economics at New York University and NBER, Department of Economics, NYU, 269 Mercer Street, 7th floor, New York, New York 10003, 212/998-8958,