We empirically characterize the mechanics of trade adjustment during the Argentine crisis. Though imports collapsed by 70 percent from 2000-2002, the entry and exit of firms or products at the country level played a small role. The within-firm churning of imported inputs, however, played a sizeable role. We build a model of trade in intermediate inputs with heterogeneous firms, fixed import costs, and roundabout production. Import demand is non-homothetic and the implications of an import price shock depend on the full distribution of firm-level adjustments. An import price shock generates a significant decline in productivity.
We explore the role of inflation credibility in self-fulfilling debt crises. In particular, we propose a continuous time model of nominal debt with the potential for self-fulfilling debt crises as in Calvo (1988) and Cole and Kehoe (2000). We characterize crisis equilibria conditional on the level of commitment to low inflation. With strong commitment, which can be interpreted as joining a monetary union or issuing foreign currency debt, the environment is a version of the one studied by Cole and Kehoe. The paper contrasts this framework with one in which sovereign debt is nominal and is vulnerable to ex post devaluation. Inflation is costly, but reduces the real value of outstanding debt without the full punishment of default. In a debt crisis, a government may opt to inflate away a fraction of the real debt burden rather than explicitly de-fault. This flexibility potentially reduces the country's exposure to self-fulfilling crises. On the other hand, the government lacks commitment not to inflate in the absence of crisis. This latter channel raises the cost of debt in tranquil periods and makes default more attractive in the event of a crisis, increasing the country's vulnerability. We characterize the interaction of these two forces. We show that there is an intermediate level of commitment that minimizes the country's exposure to rollover risk. On the other hand, low inflation credibility brings the worst of both worlds high inflation in tranquil periods and increased vulnerability to a crisis. Weak inflationary commitment also reduces the country's equilibrium borrowing limit. These latter results shed light on the notions of original sin and debt intolerance highlighted in the empirical literature; that is, the fact that developing economies issue debt exclusive in foreign currency to international investors as well as encounter solvency issues at relatively low ratios of debt-to-GDP.
We show that even when the exchange rate cannot be devalued, a small set of conventional fiscal instruments can robustly replicate the real allocations attained under a nominal exchange rate devaluation in a dynamic New Keynesian open economy environment. We perform the analysis under alternative pricing assumptions—producer or local currency pricing, along with nominal wage stickiness; under arbitrary degrees of asset market completeness and for general stochastic sequences of devaluations. There are two types of fiscal policies equivalent to an exchange rate devaluation—one, a uniform increase in import tariff and export subsidy, and two, a value-added tax increase and a uniform payroll tax reduction. When the devaluations are anticipated, these policies need to be supplemented with a consumption tax reduction and an income tax increase. These policies are revenue neutral. In certain cases equivalence requires, in addition, a partial default on foreign bond holders. We discuss the issues of implementation of these policies, in particular, under the circumstances of a currency union.