Following a sudden stop, real exchange rates can adjust through a nominal exchange rate depreciation, lower domestic prices, or a combination of both. This paper makes three contributions to understand how the type of adjustment shapes the response of macroeconomic variables, in particular productivity, to such an episode. First, using Spanish micro data during two episodes, it documents that in a currency union unproductive firms exit more than in a floating regime. Second, it proposes a small open economy DSGE model featuring firm selection, variable markups and elastic labor supply to rationalize this finding. The model nests three mechanisms through which a sudden stop affects productivity: a pro-competitive, a cost, and a demand channel. While only the former operates when the nominal exchange rate adjusts, all three are active under a currency union. The model delivers general conditions under which the positive impact of the demand channel on productivity dominates. Third, it validates the model’s aggregate predictions against a wider set of economies. In particular, it shows that the decline in productivity after a sudden stop is increasing in the flexibility of the exchange rate.

Link to paper: 01220b10-54c2-45bf-ac0e-ce28c00d1b91.filesusr.com/ugd/28cfa5_ff9fe028861c427e83c99c704d97729a.pdf