Can Miracles Lead to Crises? The Role of Optimism in Emerging Markets Crises

Authors


  • I am grateful to Enrique Mendoza, Guillermo Calvo, and John Rust for their support and suggestions. This paper has benefited from the comments of Süleyman Başak, Ceyhun Bora Durdu, Kenneth Judd, Carol Osler, John Shea, Carlos Vegh, Laura Veldkamp, and the participants of 2005 Society for Economic Dynamics Meetings in Budapest, 2006 North American Winter Meetings of the Econometric Society in Boston, and IMF Institute Lunch Seminar. All errors are my own.

Abstract

Emerging market financial crises are abrupt and dramatic usually occurring after a precrisis bonanza. This paper develops an equilibrium asset pricing model with informational frictions in which crisis itself is a consequence of the investor optimism in the period preceding the crisis. If preceded by a sequence of positive signals, a small, negative noise shock can trigger a downward adjustment in investors' beliefs, asset prices, and consumption. The magnitude of this downward adjustment increases with the level of optimism attained prior to the negative signal. Moreover, with informational frictions, asset prices display persistent effects in response to transitory shocks.

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