Impact of probability of crisis on the economy

Abstract

The increased frequency of financial crises in the last two decades led to a surge of interest in search for common elements of those crises and to the creation of early warning systems as instruments to avoid currency crises by predicting the timing of the crises. Along with the early warning systems, observation of increased frequency of crisis called forth deeper research of costs of crisis. This study combines both areas of research in it by employing a new econometric approach in assessing costs of crises. The study utilizes an early warning system in order to measure the impact of the predicted probability of crisis on the economy. Later on, the predicted probabilities of crises obtained are employed in a country-specific VAR system so as to come up with measures of consequences of currency crises. The study predicts crises for a sample of 15 emerging market economies over the period of 1980-2000. The costs of crises analysis for Latin American countries reveals that crises experienced during 1980-2000 caused significant amount of reduction in growth rates of output of those countries. Furthermore, the results suggest that the slowdown in economic activity lasts no more than two years and then the economy recovers.