Inequality and asset prices during Sudden Stops

Abstract

This paper studies the cross-sectional dimension of Fisher’s debt-deflation mechanism that triggers endogenous Sudden Stop crises — i.e., episodes with large reversals in the current account. Analyzing microdata from Mexico, we show that this dimension has macroeconomic implications that operate via opposing effects. First, an amplifying effect by which households with high leverage fire-sale their assets during crises, increasing downward pressure on asset prices. Second, a dampening effect by which wealthy households with low leverage buy depressed assets, relieving downward pressure on asset prices. As a result, the role of inequality during crises is ambiguous. We conduct a quantitative analysis using a calibrated small open economy, asset-pricing model with heterogeneous agents and aggregate risk to measure the effects of inequality during crises. The model suggests that economies with lower inequality, whether due to reduced idiosyncratic risk or wealth redistribution across agents, experience less severe crises, as observed in the data.