Staff Report 353

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Sudden Stops and Output Drops

V. V. Chari - Consultant
Patrick J. Kehoe - Consultant
Ellen R. McGrattan - Consultant

Published January 1, 2005

Abstract
In recent financial crises and in recent theoretical studies of them, abrupt declines in capital inflows, or sudden stops, have been linked with large drops in output. Do sudden stops cause output drops? No, according to a standard equilibrium model in which sudden stops are generated by an abrupt tightening of a country’s collateral constraint on foreign borrowing. In this model, in fact, sudden stops lead to output increases, not decreases. An examination of the quantitative effects of a well-known sudden stop, in Mexico in the mid-1990s, confirms that a drop in output accompanying a sudden stop cannot be accounted for by the sudden stop alone. To generate an output drop during a financial crisis, as other studies have done, the model must include other economic frictions which have negative effects on output large enough to overwhelm the positive effect of the sudden stop.


Published In: American Economic Review Papers and Proceedings (Vol. 95, No. 2, May 2005, pp. 381-387)

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