Sudden Stop Crises in Economies with Heterogeneous Agents

This paper studies the cross-sectional implications of borrowing decisions in the presence of a Sudden Stop crisis - a period of large capital outflows. I develop a Krusell-Smith type heterogeneous agent open economy model where the agents fail to internalise their influence on the relative price of non-tradables. The agents face both aggregate and idiosyncratic risks to their endowments. The aggregate shocks govern the fluctuations of the economy while the idiosyncratic shocks determine the different endowments compositions across agents. As the households have different endowment compositions with respect to the tradable and non-tradable sectors so that their exposure to exchange rate fluctuations varies. Compared to the representative agent case, the Sudden Stop crises frequency is significantly lower (the probability goes down from 5.5% to 0.28%) while the severity is slightly higher (the drop in aggregate consumption is 26% higher in the median crisis event). The presence of agents less exposed to the exchange rate risk helps to support the exchange rate and stop the debt-deflation spiral. Therefore, income heterogeneity helps to dampen the effects of the crisis. Following the representative agent models studying suboptimal borrowing behaviour, I introduce a social planner problem that takes the equilibrium price reaction into account. This allows me to study the potential loss from the externality.