Understanding the Relationship between GDP growth Expectations and Financial Crises

MARTIN GUZMAN

Montevideo

Mesa redonda; IEA and BCU Roundtable on Capital Flows, Capital Controls and Monetary Policy; 2013

International Economic Association and Banco Central del Uruguay

This paper explores two dimensions of the relationship between GDP growth expectations and financial crises. The first dimension is the relationship between volatility of GDP growth expectations and the frequency of financial crises. I describe the necessity of a high variance of expected permanent income to explain the frequency of crises we observe in highly volatile economies, and I show how models with learning about GDP growth trends are able to generate that high variance. The second dimension is the relationship between volatility of GDP growth expectations and the severity of financial crises, measured by output losses. I show that more stability of expectations is associated to more severe debt and banking crises, consistent with the Minsky financial instability hypothesis. Hence, more volatile countries have a higher probability of crisis, but a crisis tends to be more severe when it is preceded by long periods of stability.