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Contractionary devaluation and credit crunch:

Marcus Miller, Javier García Fronti and Lei Zhang

October 2005

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Sharp economic contraction often follows currency devaluation in emerging markets - due mainly to liability dollarisation. Such adverse balance sheet effects play a key role in the well-known model of Aghio et al (2000), by reducing investment and future supply. We show how the prompt contraction of output can be accounted for by incorporating demand failure - due to a slow export response and a credit crunch. The resulting eclectic framework is used to study the collapse of the Argentine economy when Convertibility ended in 2002; and to see why efforts to imitate President Roosevelt by 'pesifying' the economy proved counter-productive.