Temporary Stabilizations, Sudden Stops and Asset Prices

This paper studies a temporary exchange rate based stabilization plan in which agents face a sudden stop of capital inflows. The model generates a rising path of real interest rates in advance of the exchange rate collapse. This generates a time-dependent non-monotonic path of required premium on domestic assets. The model-generated asset price dynamics closely mimics its empirical counterpart as witnessed during recent collapses of exchange rate based stabilization plans. The model also reproduces consumption and foreign reserve dynamics that closely mimic the data.