2008a), "Sudden Stops, Sectoral Reallocations and the Real Exchange Rate", Federal Reserve Bank of Minneapolis Sta¤Report 391

A “sudden stop ” of foreign capital flows in a developing country tends to be followed by a switch from trade deficits to surpluses, a sharp depreciation of the real exchange rate, and a decrease in output and total factor productivity. We further document that there is substantial reallocation taking place across the nontradable and tradable good sectors. Using Mexico’s 1994-95 crises as an archetypal example, we find that output falls more in the nontradable goods sector and recovers more slowly than in the tradable goods sector as labor and capital are shifted from the nontradable to the tradable good sector. We construct a multisector model in which it is costly to shift resources across sectors, and calibrate it to the Mexican economy. In contrast to other models of sudden stops, we do not model any other shocks affecting the economy, which allows us to isolate the effects of the sudden stop. When the calibrated model is subjected to a sudden stop of capital inflows it is able to replicate the sectoral patterns we find in the data and account for the movements in the real exchange rate and the relative price of tradables and nontradables