Research

Abstract: We study how belief distortions and uncertainty amplify sudden stop crises by embedding representativeness—formalized as Smooth Diagnostic Expectations—into a small open economy with occasionally binding collateral constraints and stochastic income volatility. Calibrated to survey and macro-financial data and solved globally, the model delivers a new variance-driven amplification channel of the Fisherian debt–price spiral: distorted beliefs, interacting with uncertainty, generate optimism, over-borrowing behaviors, and rising crisis risk, until a collapse in collateral values triggers pessimism, precautionary behaviors, and tighter borrowing constraints. Analytically, we show that income variance shocks generate history-dependent belief reactions to forecast revisions and, even absent changes in income levels, induce state-dependent collateral tightening. In simulations, sudden stop events are more frequent, sharper, and asymmetric than under rational expectations—producing larger crashes after optimistic build-ups and slower recoveries after pessimistic downturns.