NEW PERSPECTIVES ON REPUTATION AND DEBT † Sudden Stops and Output Drops

Recent financial crises in emerging markets have included two features: abrupt declines in capital inflows, commonly known as sudden stops (Guillermo Calvo, 1998), and large declines in output. Here we ask whether theory predicts that these two features are related: do sudden stops necessarily lead to output drops? We ask this in a standard equilibrium model in which sudden stops are generated by an abrupt tightening of a country’s collateral constraint on foreign borrowing. Theory’s answer is no; sudden stops, by themselves, do not lead to decreases in output, but rather to increases. To generate an output drop during a financial crisis, the model must include other frictions which have negative effects on output that are large enough to overwhelm the positive effect of the sudden stop. We begin by setting up a standard model of a small open economy in which foreign borrowing is subject to a collateral constraint. We view fluctuations in this collateral constraint as arising from fluctuations in a country’s reputation. In the model, the country’s budget constraint implies that an abrupt decrease in capital inflows produces an abrupt increase in net exports. Following our earlier approach (in Chari et al., 2004), we show that the equilibrium outcomes in the small open economy are equivalent to those of a closedeconomy prototype growth model of the kind widely used in the business-cycle literature. In particular, we show that a rise in net exports in the small open economy corresponds to a rise in government consumption in the prototype model. It is well known that an increase in government consumption produces an increase in output in models like our prototype growth model. A sudden stop that produces an increase in net exports in the small open economy thus also leads to an increase in output. We demonstrate this quantitatively with data from Mexico in the mid-1990s. In three other studies, researchers have built small open-economy business-cycle models in which sudden stops lead to output drops. In these studies, however, output drops because of other frictions that overwhelm the direct effect on output from sudden stops. In all three studies, firms must borrow in advance to pay for inputs to production. In Pablo Neumeyer and Fabrizio Perri (2004), firms must borrow to pay for a fraction of the wage bill, while in Lawrence Christiano et al. (2004) and Enrique Mendoza (2004), firms must borrow to pay for foreign intermediate inputs. This payment-inadvance requirement, by itself, does not introduce a friction because firms can simply borrow at the market interest rate to make the payments. In Neumeyer and Perri (2004) and Mendoza (2004), the key friction is that firms are effectively required to put the funds in a non-interestbearing escrow account. In Neumeyer and Perri, this requirement introduces a wedge between the marginal product of labor and the marginal rate of substitution between leisure and consumption. In Mendoza, this requirement produces a shock to total factor productivity. In Christiano et al. (2004) the payment-in-advance requirement interacts with the collateral constraint to produce a shock to total factor productivity. Here we demonstrate in a version of our model that the output drops in these studies are not due to the sudden stops alone.