Frequency and Severity of Current Account Reversals: An Analysis with a Rational Expectations Regime Switching DSGE Model

We employ a small open economy model with debt-deflation, where agents form expectations regarding sudden stops—typically characterized by a combination of current account reversals and sharp output declines. To this end, we construct a rational expectations regime switching DSGE model with occasionally binding collateral constraints. In environments with frequent sudden stops, agents anticipate future occurrences more strongly. Heightened expectations of losing access to international financial markets prompt collateral-constrained households to increase precautionary savings. These additional savings help sustain consumption and support collateral prices during turbulent periods, counteracting capital flight. However, as sudden stops become more frequent, the welfare loss due to pecuniary externalities intensifies, necessitating stronger macroprudential capital control measures. We provide empirical evidence from emerging economies that aligns with our theoretical findings.