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The paper discusses a model in which growth is a negative function of fiscal burden. Moreover, growth discontinuously switches from high to low as fiscal burden reaches a critical level. Growth collapse is associated with a sudden stop of capital inflows, real depreciation and a drop in output (driven by a fall in the output of nontradables)-all of which have occurred during recent financial crises in emerging markets. The monetary version of the model is employed to show that balance of payments (BOP) crises could be a result of fiscal distortions. In particular, it is further argued that BOP crisis could be a justifiable central bank response to growth collapse, although realistic circumstances may make this response highly ineffective. An important policy implication of the model is that in order to avoid sudden stop crises, policymakers should aim at improving fiscal institutions. Lowering the fiscal deficit is highly effective in the medium term, but could be counterproductive in the short run if it relies on higher taxes.
Since Mexico's tequila crisis of 1994/5, emerging market economies (EM) have entered a period of recurrent crises that go far beyond currency crises as experienced in advanced economies. EM crises are characterized by sharp recession, high unemployment, and an alarming rise in the number of people living below the poverty line. A common feature of these episodes is a sudden stop (SS), namely, a large reduction in the flow of international capital.1 This is illustrated in Table 1 which, incidentally, shows that the phenomenon predates the tequila crisis. Moreover, Calvo and Reinhart (2001) show that, on the whole, SS is absent in advanced countries. This leads me to the conjecture that SS is perhaps the central feature of EM crises from which all the others follow. Developing a theory that rationalizes the conjecture is a challenging task because EM crises have not been preceded by sharply deteriorating fundamentals (see Calvo and Mendoza, 1996a and b, for the case of Mexico). Thus, to model this fact, the theory should ideally be able to display market equilibrium discontinuity as a function of market fundamentals.
The basic model presented at the outset exhibits equilibrium discontinuity. A key assumption is that government expenditure has to be partly financed by output taxes,...