Sudden Stops and Output Drops: Can Theory Link the Two?

33 Pages Posted: 9 Oct 2006

Date Written: October 7, 2006

Abstract

Empirical literature overwhelmingly suggest that sudden stops lead to output drops. Can general equilibrium theory predict this link or is it theoretically impossible for sudden stops to generate output drops by themselves as other studies suggest? In this paper we contend that the answer depends on the response of labor to a sudden stop which in turn depends on the type of preference specification used. To this end, we use a small open economy model where agents face a constraint on foreign borrowing and a sudden stop occurs due to an abrupt tightening of the borrowing constraint. We find that under Cobb-Douglas preferences, the dominant wealth e¤ect of a sudden stop leads to labor increases which in turn generates an output increase as opposed to a drop! In contrast, under GHH preferences that by construction eliminate the wealth effect, a sudden stop leads to declines in future capital and labor supply leading to drops in output. We find empirical support of our conclusion in data from a sample of emerging economies where labor declined significantly in the aftermath of a sudden stop.

Keywords: sudden stops, output drops, dynamic general equilibrium, preferences

JEL Classification: F34, F41

Suggested Citation

Chakraborty, Suparna, Sudden Stops and Output Drops: Can Theory Link the Two? (October 7, 2006). Available at SSRN: https://ssrn.com/abstract=935791 or http://dx.doi.org/10.2139/ssrn.935791

Suparna Chakraborty (Contact Author)

University of San Francisco ( email )

2130 Fulton Street
San Francisco, CA 94117-1080
United States

HOME PAGE: http://chakrabortys.weebly.com

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