TY - JOUR AU - Durdu,Ceyhun Bora AU - Mendoza,Enrique G. AU - Terrones,Marco E. TI - Precautionary Demand for Foreign Assets in Sudden Stop Economies: An Assessment of the New Merchantilism JF - National Bureau of Economic Research Working Paper Series VL - No. 13123 PY - 2007 Y2 - May 2007 UR - http://www.nber.org/papers/w13123 L1 - http://www.nber.org/papers/w13123.pdf N1 - Author contact info: Bora Durdu Federal Reserve Board Division of International Finance 20th Street and Constitution Avenue NW Washington, DC 20551 Tel: (202) 452 3755 E-Mail: bora.durdu@frb.gov Enrique G. Mendoza Department of Economics University of Maryland College Park, MD 20742 Tel: 301/405-3845 Fax: 301/405-7835 E-Mail: mendozae@econ.umd.edu Marco Terrones Research Department International Monetary Fund 700 19th Street, N.W. Washington DC 20431 E-Mail: mterrones@imf.org AB - Financial globalization was off to a rocky start in emerging economies hit by Sudden Stops since the mid 1990s. Foreign reserves grew very rapidly during this period, and hence it is often argued that we live in the era of a New Merchantilism in which large stocks of reserves are a war-chest for defense against Sudden Stops. We conduct a quantitative assessment of this argument using a stochastic intertemporal equilibrium framework with incomplete asset markets in which precautionary saving affects foreign assets via three mechanisms: business cycle volatility, financial globalization, and Sudden Stop risk. In this framework, Sudden Stops are an equilibrium outcome produced by an endogenous credit constraint that triggers Irving Fisher's debt-deflation mechanism. Our results show that financial globalization and Sudden Stop risk are plausible explanations of the observed surge in reserves but business cycle volatility is not. In fact, business cycle volatility has declined in the post-globalization period. These results hold whether we use the formulation of intertemporal preferences of the Bewley-Aiyagari-Hugget class of precautionary savings models or the Uzawa-Epstein setup with endogenous time preference. ER -