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

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.