Macroeconomics in Times of Liquidity Crises

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by Calvo

ISBN: 9780262336024 | Copyright 2016

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Since the subprime mortgage crisis that began in 2007, advanced economies have felt a nagging sense of insecurity. In parallel, the profession has witnessed phenomena that are alien to mainstream macroeconomic models. Financial crises are systemic, occurring simultaneously in different economies. In this book, Guillermo Calvo focuses on liquidity factors as a commonality in financial crises. Specifically, he examines the role of “liquidity crunch” in triggering crises. He also identifies a fundamental (but overlooked) idea in Keynes’s General Theory, termed by Calvo the price theory of money, to rationalize the resiliency of the U.S. dollar when other dollar-backed assets suffered a devastating liquidity crunch.

Calvo shows that a sharp focus on liquidity reveals some characteristics of liquid assets that are easy to miss otherwise. He argues for liquidity’s centrality, presenting what he calls the Liquidity Approach. He shows that simple extensions of standard monetary models help rationalize the implications of the liquidity crunch, and then examines slightly more technical models that highlight liquidity issues. He explores the empirical effects of liquidity crunch by studying systemic system stops (of capital inflows), presuming that they are triggered by liquidity crunch-type phenomena.

“A basic definition of liquidity in economics refers to how easy it is to convert an asset to cash. Liquidity is fickle in times of crisis and yet its role is often overlooked in standard crises explanations. Guillermo Calvo’s elegant analysis of the elusive concept of liquidity coupled with his insightful studies of some of the major crises of the past few decades make this book essential reading for economists, investors, and policy makers who are interested in gaining a deeper understanding of financial crises and their impacts.”

—Carmen M. Reinhart, Minos A. Zombanakis Professor of the International Financial System, Harvard University; coauthor of This Time Is Different: Eight Centuries of Financial Folly

“Liquidity accounts for both the strengths and the weaknesses of modern monetary economies, claims Guillermo Calvo. His price theory of money gives new meaning to the old adage that an emerging currency is one from which one tries to emerge in an emergency. Essential reading for anyone trying to understand recent financial crises in both rich and poor nations.”

—Andrés Velasco, Professor of Professional Practice in International Development, Columbia University

“Throughout his distinguished career, Guillermo Calvo has always sought to uncover the deeper economic truths that surround us. With this book, he does it again! Calvo forces us to re-calibrate our intellectual frameworks to grasp some of the most important questions: What lies behind financial crises? Which macro stabilization policies should we pursue? What accounts for the structure of the international monetary system? He argues convincingly that liquidity plays a major role in all these phenomena. Intellectually stimulating, his new book opens new vistas for future research.”

—Pierre-Olivier Gourinchas, Professor of Economics, University of California, Berkeley; editor-in-chief of IMF Economic Review

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Contents (pg. vii)
Preface (pg. ix)
Introduction (pg. xv)
I Toward the Liquidity Approach (pg. 1)
1 Financial Crises and the Slow Mutation of Conventional Wisdom (pg. 3)
Crises in Emerging Market Economies: Onset (pg. 4)
Crises in Emerging Market Economies: Recovery (pg. 9)
The Subprime Crisis (pg. 12)
Quantitative Easing, Tapering, and Central Bank Interest Rates (pg. 18)
Summary and Next Step (pg. 21)
2 The Liquidity Approach to Financial Crises (pg. 23)
Liquidity and Its Demise: Liquidity Crunch (pg. 24)
A Resilient Dollar—The Price Theory of Money to the Rescue! (pg. 28)
Multiple Currencies (pg. 31)
Liquidity Crunch and Sudden Stops: Collateral Damage (pg. 33)
Policy Challenges under Liquidity Deflation, and Other Forms of Liquidity Mischief (pg. 37)
Complementary Notes on the Price Theory of Money (pg. 46)
A Semantic Note (pg. 48)
Summary and Implications (pg. 48)
3 Monetary Theory: Overview and Liquidity Extensions (pg. 51)
Modeling “Money”: Some Basic Issues (pg. 52)
A Barebones Central Bank Rational Expectations Model (pg. 54)
Accounting for Liquidity Effects: Demand Side (pg. 61)
Accounting for Liquidity Effects: Supply Side (pg. 66)
Banks and Credit (pg. 70)
Monetary Theory in Times of Crisis: A Critical Assessment (pg. 72)
4 Nominal Anchoring with Liquid Monetary Policy Assets (pg. 75)
Taylor’s Principle and Total Liquidity (pg. 75)
Flexible Prices (pg. 77)
Staggered Prices (pg. 81)
Closing Remarks (pg. 83)
5 Liquidity Crunch/Trap: Some Unconventional Output/Employment/ Growth Implications (pg. 85)
Introduction (pg. 85)
Basic Model (pg. 88)
Monetary Policy and Growth (pg. 99)
Slow Jobless/Wageless Recovery after Crisis: Key Items for the Research Agenda (pg. 105)
Appendix (pg. 107)
II Emerging Market Crises through the Lens of the Liquidity Approach (pg. 109)
Introduction to Part II (pg. 111)
6 Systemic Sudden Stops: Crises and Recoveries in EMs (pg. 117)
Methodology (pg. 118)
Sudden Stop and Bank Credit Flows (pg. 120)
Relative Prices (pg. 123)
Aggregate Investment, Consumption, and Exports (pg. 125)
Output Dynamics (pg. 128)
Employment, Capital, and Measured TFP (pg. 130)
Conclusions (pg. 133)
Appendixes (pg. 134)
Appendix A Data (pg. 134)
Appendix B Sample (pg. 137)
Appendix C Statistical Tests (pg. 139)
7 Systemic Sudden Stops: The Relevance of Balance-Sheet Effects and Financial Integration (pg. 143)
Basic Framework (pg. 145)
Sudden Stops: Definition and Characterization (pg. 150)
Determinants of Sudden Stops: Empirical Analysis (pg. 156)
Conclusions (pg. 170)
Appendix Tables (pg. 173)
Data Appendix (pg. 190)
Technical Appendix: Inference with RandomEffects Probits under Endogeneity (pg. 195)
Notes (pg. 201)
References (pg. 217)
Index (pg. 233)

Guillermo A. Calvo

Guillermo A. Calvo is Professor of International and Public Affairs at Columbia University’s School for International and Public Affairs. He is the author of Money, Exchange Rates, and Output, Emerging Capital Markets in Turmoil (both published by the MIT Press) and other books.

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