Capital inflow-terms of trade ‘nexus’: Does it lead to financial crisis?

The paper models the nexus of foreign capital inflow and dynamic terms of trade to explain financial crisis in the form of sudden stop or reversal of capital inflow. Crisis in this structure is rooted in the role played by dynamic terms of trade rather than informational imperfections as generally found in the existing literature. Inspite of satisfying the regularity conditions for model consistency episodes of sudden crises get magnified due to the non-linearity of the equilibrium relations. This is the novelty of this paper and differentiates it from the standard theoretical literature, and well captures empirical evidence documented in the literature. Non-linearity plays a very important role in the model. Expectation of the exchange rate depreciation has higher potential to generate a financial crisis than shift in the risk perception of foreign lenders or supply shock in the borrowing country.