A Model of Financial Crises in Emerging Markets

Abstract

We develop a model in which financial crises in emerging markets may occur when domestic banks are internationally illiquid. Runs on domestic deposits may interact with foreign creditor panics, depending on the maturity of the foreign debt and the possibility of international default. Financial liberalization and increased inflows of foreign capital, especially if short term, can aggravate the illiquidity of banks and increase their vulnerability. The primary role of illiquidity is consistent with the existence of asset price booms and crashes and of government distortions.