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 over-whelm the positive effect of the sudden stop.
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