External finance, sudden stops and financial crisis: what is different this time?

This paper develops a two-country dynamic, stochastic general equilibrium(DSGE) model to investigate the transmission of a global financial crisis to a small open economy. Central to our framework are financial frictions that play a major role in the macroeconomic adjustment to global credit tightening. We find that small open economies hit by a sudden stop arising from financial distress in the global economy are likely to face a more prolonged crisis than when they experience a financial shock of domestic origin. This is because an important source of difficulty in responding to a global financial crisis is the inability of countries to export their way out of crisis due to the slump in world consumer demand initiated by the global financial distress -as is painfully experienced by many countries in contemporary times. Moreover, we show that the greater a country's trade integration with the rest of the world, the greater the fluctuation of its macroeconomic aggregates in response to a global financial crisis.