Financial Frictions, Distribution Costs, and Current Account Crises

Current account crises in emerging markets are characterized by large increases in interest rates, big drops in output, and large real currency depreciations. Current models of crisis with financial frictions do not generate very large movements in these variables. Recent work has shown that the introduction of distribution costs, in otherwise standard open-economy models, can work to amplify the movements in real exchange rate. In this paper, we model a distribution sector that combines tradables and nontradables to produce a consumer good and also faces a financing constraint. In our model, a large increase in interest rates raises the cost of distributing goods and therefore brings about a fall in the supply of distribution services. In turn, the increase in the cost of distribution triggers a fall in tradable output, via a fall in the demand for traded goods. We find that the introduction of distribution services amplifies the responses of output, imports, and the real exchange rate in episodes of current account crises