Allocative Inefficiency during a Sudden Stop

Abstract

Aggregate production and total factor productivity (TFP) fall dramatically during sudden stop episodes. During these episodes, domestic demand contracts, while foreign demand remains largely stable, and exchange rate depreciation favors exporters. This shift leads to a relative expansion of export-oriented activities over domestic-oriented activities. Due to a combination of differences in market power and tax treatment, export-oriented activities exhibit lower revenue-based TFP (TFPR) than domestic-oriented activities. Consequently, the reallocation of resources toward export-oriented activities reduces aggregate TFP. Leveraging detailed microdata from Mexico, I provide new empirical evidence demonstrating the difference in distortions and reallocations of resources at the plant–product–destination level during the 1994 sudden stop. I then build a multisector small open economy new Keynesian model and show that reallocation effects explain about 50% of the observed decline in value added in the manufacturing sector.