Crisis in an open economy portfolio balance approach

The dissertation develops a portfolio-balance model to show that a currency crisis following capital flight can occur in an open economy without any dramatic shift in the underlying fundamentals. The crisis is of liquidity brought about by sudden withdrawals of foreign capital from the financial market. Once a crisis hits, the traditional IMF policy of austerity may not work and may in fact worsen the crisis. It is also possible that an economy at the border of equilibrium may be thrown into disequilibrium if any of the restrictive policies are pursued. The instability is rooted in the formation of market perception of risk associated with tradable short-term assets. Perceived risk makes asset demand functions nonlinear, which is instrumental in determining whether financial markets are stable, and if a stable economy eventually returns to equilibrium when subjected to a financial shock.