Allocative Inefficiency during a Sudden Stop

Abstract

Aggregate production and total factor productivity (TFP) fall dramatically during sudden stop episodes. During these episodes, domestic aggregate demand contracts, while foreign aggregate 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 face smaller distortions. Therefore, a sudden stop causes a decline in TFP by shifting resources from high-distortion to low-distortion activities. Exchange rate depreciation, combined with dollar-currency pricing, shrinks the ex-post distortion differential, thereby mitigating the decline in TFP to a second-order. 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.