Financial Frictions and Total Factor Productivity: Accounting for the Real Effects of Financial Crises pot

The model is also consistent with a current account reversal and a real exchangerate depreciation as observed in the data.However, the baseline model also predicts that the depreciation

Financial Frictions and Total Factor Productivity: Accounting for

the Real Effects of Financial Crises1

Hunter College & Graduate Center,

City University of New York

CIE & Dept of Economics,

ITAM

June 2010

Abstract.- The financial crises or “sudden stops” of the last decade in emergingeconomies were accompanied by a large fall in total factor productivity In this paper weexplore the role of financial frictions in exacerbating the misallocation of resources andexplaining this drop in TFP We build a dynamic two-sector model of a small open economywith a cash in advance constraint where firms have to finance a part of their purchase ofintermediate goods prior to production The model is calibrated to the Mexican economybefore the 1995 crisis and subject to an unexpected shock to interest rates The financialfriction can generate an endogenous fall in TFP of about 3.5 percent and can explain 74percent of the observed fall in GDP per worker Adding a cost of adjusting labor betweenthe two sectors and sectoral specificity of capital also generates the sectoral patterns ofoutput and resource use observed in the data after the sudden stop The results highlightthe interaction between interest rates and allocative inefficiencies as an explanation of thereal effects of the financial crisis

1 Email: sangeeta.pratap@hunter.cuny.edu, currutia@itam.mx.

We are grateful to Roberto Chang, Tim Kehoe and Kim Ruhl for helpful comments We also appreciate comments from participants at the Latin American Meetings of the Econometric Society, Econometric Society Winter Meetings, the meetings of the Society for Economic Dynamics, the Midwest Macro Meetings and the Cornell-Penn State Macro Workshop Seminar participants at Drexel University, ITAM and Wesleyan University also provided helpful feedback Vicente Castañon, Lorenza Martinez, Jose Luis Negrin and Jessica Serrano at the Banco de Mexico, and Reyna Gutierrez at the Secretaria de Hacienda y Credito Publico provided invaluable help with the data We are also grateful to Erwan Quintin and Vivian Yue for making their computations available to us Raul Escorza and Nate Wright provided excellent research assistance The paper was partly written while Pratap was a Fernand Braudel fellow at the European University Institute and Urrutia was visiting the International Monetary Fund’s Institute We gratefully acknowledge the hospitality of these institutions This work was supported in part by a grant from the City University of New York PSC-CUNY Research Award Program We are responsible for all errors.

1 Introduction

The financial crises of the last decade in emerging economies have been accompanied by alarge fall in total factor productivity As Calvo et al (2006) show, GDP in these suddenstop episodes declined on average by 10 percent, the bulk of which can be attributed to adrop in TFP.2 Investigating the forces behind these movements in total factor productivity

is central to understanding the real effects of financial crises

A decline in TFP of this magnitude must be a result of not merely a misallocation

of resources, but a misallocation that worsens during crises In this paper we explore therole of financial frictions in exacerbating existing inefficiencies and explaining the drop inTFP There is ample micro evidence that financial constraints and the increase in the cost

of credit affected the performance of firms during the crisis,3 however their aggregate impact

on output is unclear

We build a deterministic dynamic two-sector model of a small open economy with acash in advance constraint where firms have to finance a part of their purchase of intermediategoods prior to production The economy consists of a traded and non traded goods sector,each of which use labor, capital and intermediate goods to produce output The output ofboth sectors is combined to produce a final good and an intermediate good The former

is used as both a consumption and an investment good and the latter for production Theeconomy exports and saves in traded goods Besides intertemporal adjustment costs forcapital, the financial constraint for intermediate goods is the only friction in the baselinemodel

An exogenous increase in interest rates has a twofold effect First, it increases the wedgebetween the producer cost and the user cost of intermediate goods and worsens existingallocative inefficiency The main objective of our paper is to quantify the impact of thischannel on TFP Second, an increase in interest rates also increases the demand for tradedgoods, leading to an increase in their price and a real exchange rate depreciation

2 The sudden stop episodes studied include the Latin American debt crises of the 1980s, the Mexican crisis

of the first half of the 1990s and the East Asian and Russian crises of the late 1990s On average, more than

85 percent of the fall in output observed during these episodes can be attributed to the fall in TFP.

3 Aguiar (2005) and Pratap et al (2003) show that the presence of dollar denominated debt depressed firm investment during the 1994 crisis in Mexico Pratap and Urrutia (2004) build a model that accounts

We calibrate our model to the Mexican economy prior to the sudden stop of 1994 andintroduce the sequence of interest rates observed in Mexico during the sudden stop as anunexpected shock The experiment delivers a reduction in TFP of about 3.5 percent whichaccounts for 52 percent of the TFP drop in the data and 74 percent of observed fall in GDPper worker The model is also consistent with a current account reversal and a real exchangerate depreciation as observed in the data.

However, the baseline model also predicts that the depreciation of the real exchangerate reallocates inputs from the non traded to the traded goods sector, leading to a largeincrease in the output of the latter and an equally large decline in that of the former As weshow in the following section, this runs counter to the facts No such immediate reallocation

of labor or capital towards the traded goods sector took place in Mexico, and output fell inboth sectors We therefore introduce two further frictions: a cost of adjusting labor betweenthe two sectors, and sectoral specificity for capital.4 We find that adding these frictions tothe model allows us to match the sectoral patterns of output and factor movements observed

in the data, while we still obtain a large decline in TFP during the sudden stop Moreover, weshow that labor and capital reallocation frictions on their own are not sufficient to generate

a fall in GDP

Our paper borrows a key insight from Chari, Kehoe and McGrattan (2005) who showthat a sudden stop cannot generate a fall in output in a frictionless economy They suggestthat financial constraints on the purchase of inputs can generate TFP effects and outputdrops only if they create a wedge between the user and producer price of these inputs Webuild a fully fledged model with such constraints and quantitatively assess their plausibility

to explain the real effects of financial crises

We also contribute to a more general literature on financial frictions and sudden stops

in emerging economies Models such as Mendoza (2010) and Mendoza and Yue (2009) usefinancial frictions as a device to amplify the economy’s response to a sequence of bad realiza-tions of exogenous TFP shocks In contrast, we do not think of crises as regular business cyclephenomena We show that in an economy with no productivity shocks, financial frictions can

4 Pratap and Quintin (2010) show that intersectoral movements of labor depreciate human capital during the Mexican crisis Ramey and Shapiro (2001) show that there is a large degree of asset specificity in capital goods.

endogenously generate a large fall in TFP after an unexpected interest rate shock In thissense, our paper complements the analysis in Kehoe and Ruhl (2009), who demonstrate thatdeterministic two-sector models of a small open economy can reproduce the current accountreversal and real exchange rate depreciation following a sudden stop Without financialfrictions however, their model cannot generate an output drop.5

Finally, our paper is also closely related to Neumeyer and Perri (2005) who also analyzethe role of a financial friction, modelled as a cash-in-advance constraint for firms, as apropagation mechanism for external interest rates shocks However, unlike their model, ourfriction affects the purchase of intermediate goods instead of the wage bill, which allows us

to obtain TFP effects In their model, any output drop generated by an increase in interestrates is due to a decline in the labor supply and equilibrium employment As discussedbefore, sudden stops in emerging economies are characterized by large falls in TFP andcomparatively minor reductions in labor so we simplify our model and consider labor supply

to be exogenous

The paper is organized as follows The next section presents the empirical evidence onthe Mexican financial crisis In section 3 we set out the baseline model with the financialfriction and calibrate it to the Mexican economy We subject this economy to an increase

in interest rates and show that, while our model can account for a large fraction of the fall

in aggregate TFP and output, we cannot account for the patterns in sectoral reallocation ofoutput and factors of production observed in the data In Section 4 we introduce the laborand capital friction and show that they are necessary to account for the fall in output in eachsector and the flows of labor and capital across sectors Section 5 performs some robustnesschecks and Section 6 concludes

5 Benjamin and Meza (2009) analyze the real effects of Korea’s 1997 sudden stop and attempt to generate TFP effects out of a purely financial crisis Their mechanism is not financial frictions, but reallocation of resources towards low-productivity sectors, which in their model correspond to non-tradable, consumption goods We do not observe such a pattern in the Mexican data Moreover the TFP effects of their reallocation

Figure 1: Real Exchange Rate and Real Interest Rate in Mexico

Exchange Rates and Interest Rates The main events associated with the Mexicancrisis of 1994 are well documented On December 20 1994, the government devalued thepeso by 15 percent in response to capital outflows and a run on the currency When thisproved insufficient to halt capital flight, the peso was allowed to float two days later Between

1994 and 1995, the real exchange rate depreciated by more than 55 percent

The left panel of Figure 1 shows the evolution of the multilateral, CPI based, realexchange rate (peso to the dollar), calculated by the Central Bank of Mexico using a basket

of 118 currencies The dotted line shows the ratio of the prices in the traded goods sector

to prices in the non-traded goods sector.6 The increase in this price ratio due to the ation was 8 percent, a much smaller magnitude than the 58 percent depreciation of the realexchange rate The subsequent trend however, mirrored the behavior of the real exchangerate and the series edged closer from 1998 onwards

devalu-Interest rates shot up simultaneously The right panel of the same figure shows ameasure of the domestic interest rate in dollar terms based on the return on 28 day Mexican

6 While the precise definition of a traded or non traded good is sometimes contentious, we define the traded goods sector as comprising of agriculture, manufacturing and mining, while the non traded goods sector consists of construction, and all services The price index of each sector is calculated as the weighted average of the price indices of all the economic activities encompassed by it The weights are calculated as the share of the activity in sectoral value added.

treasury bills (CETES).7 As observed, the interest rate fell steadily from 1988 to 1994, aperiod of financial liberalization in Mexico During the sudden stop it increased to almost

50 percent, from a level of 7 percent in 1994 In 1996 it fell slightly to 30 percent and slowlydeclined to pre-crisis levels This is the change in interest rates that we will use for the crisisscenario Its large magnitude reflects not only the perceived risk of default of the Mexicangovernment8 but also the quantitative restrictions to borrowing implied by the sudden stop

of foreign capital

It is hard to get a direct measure of the real cost of short run borrowing for businesses

in Mexico during the crisis, but casual evidence suggests that it was not far off the 50 percentimplied by the ex-post CETES rate in dollars.9 We also provide in Figure 1 an alternativemeasure based on firm level data of (arguably large) Mexican firms listed on the stock market

We calculate the cost of credit for the median firm as the ratio of the real value of interestpayments to the real value of the stock of bank debt As observed in the figure, this realimplict interest rate increased from 17 percent in 1994 to 42 percent in 1995, and declined

to 30 percent the year after, very much in line with the ex-post CETES rate in dollars

Output and TFP The real effects of the devaluation and interest rate hike were diate The top left panel of Figure 2 shows that GDP, which had been growing at about 4percent per annum fell by over 6 percent in 1995 This decline was more pronounced in thenon traded goods sector than in the traded goods sector, as the second and third panels ofthe figure show

imme-Using detrended data on sectoral value added, labor and capital we perform a standardgrowth accounting exercise to decompose the fall in GDP in 1995.10 We use detrended data

7 In our model, all quantities, including the rate of interest will be expressed in terms of the traded good The domestic interest rate in terms of dollars is the closest analog to this in the data Ideally, we would like

to have an ex-ante interest rate in dollars, but the information to construct it is not available Instead, we construct an ex-post short run rate as the difference between the interest rate in pesos and the devaluation rate over the next month.

8 For example, the return on the J.P Morgan Emerging Markets Bond Index Plus (EMBI+) for Mexico increased from 5 to 15 percent from 1994 to 1995, and remained close to 10 percent till the end of 1996 (see Uribe and Yue 2006) This index captures the country specific risk of sovereign default.

9 In April 1995, the New York Times reported that entrepreneurs faced interest rates of over 100% On August 24 of the same year the Mexican government announced a $1.1 billion plan to guarentee interest rates at half their current level Under the plan, the interest rate on the first $31,400 of business loans would

be reduced from about 60% to 25%.

Table 1: Growth Accounting for Mexican Economy - Detrended Variables

Annual Growth Total Traded Non-traded

The lower right panel of Figure 2 shows the evolution of aggregate and sectoral trended TFP during and following the Mexican crisis The immediate collapse in TFP washigher in the non-traded sector During the recovery TFP grew at a faster rate in the tradedsector (2.2 percent per year) than in the non-traded sector, where productivity staganatedfor the rest of the decade

de-Decline in Intermediate Inputs While output fell without a corresponding drop inmeasured labor and capital, there was a large decline in the use of intermediate inputs.From NIPA data, we estimate this fall to be around 4.8 percent in 1995 Moreover, theconsumption of energy, one of the most important intermediate goods, fell by over 10 percent

in this period, as documented by Meza and Quintin (2006)

The use of trade credit, which is typically used to finance intermediate good tion also fell in this period While macro data on trade credit is not available, data fromfirms listed on the Mexican stock exchange show that as a fraction of short term liabilities,the stock of trade credit outstanding fell from 24 percent in December 1994 to 20 percent

consump-by the end of 1995 Recovery to pre-crisis levels occurred only consump-by 1997

for capital stock by sector is obtained from Banco de Mexico surveys We use the factor shares α T

= 0.48,

αN= 0.36, and α = 0.4 The choice of these values will be discussed in detail in the calibration section.

11 Labor is detrended at the annualized rate of growth of total employment from 1988 to 2002 (n = 0.0195) Capital and GDP are detrended at the rate (1 + g) (1 + n)−1, where g = 0.0125 corresponds to the annualized growth rate of per worker GDP in the same period Finally, TFP is detrended at the rate (1 + g)1−α− 1.

We use the same rates to detrend total and sectoral variables.

Share in Productive Factors

0.2 0.3 0.4 0.5 0.6 0.7

in the importance of the traded goods sector as services eclipsed manufacturing in tance The large devaluation in 1995, together with the passage of NAFTA the year before,reversed this trend in output and the share of traded goods in output increased by about0.8 percent in that year, consistent with the trends for sectoral TFP discussed before.12Interestingly, this was not accompanied by a similar increase in the share in labor andcapital While the pace of the decline in the share of labor slowed, and the share of capitalincreased after about two years, no large and immediate reallocation of resources took place,

impor-as a standard frictionless model would predict after the devaluation This suggests that costs

of adjustment of labor and capital can be important in explaining the response of output inboth sectors

12 Meza and Urrutia (2010) analyze the long run behavior of the real exchange rate in Mexico and linked

it to this process of structural transformation of the economy, together with a decline in the cost in foreign borrowing due to financial liberalization.

3 The Baseline Model

In this section we set up the baseline model with the financial friction As mentionedearlier, the model economy is a small open economy which produces traded and non-tradedgoods Both goods are combined to produce a final good which is consumed and invested.Traded and non traded goods are also combined to produce the intermediate good used

in their production In addition, the traded good is exported and used for borrowing andlending A representative firm in each sector produces according to a constant returns toscale production function using capital, labor and intermediate goods

We introduce the financial friction as a working capital requirement for production As

in Mendoza and Yue (2009), intermediate goods must be purchased in advance of productionusing (short term) borrowing in traded goods.13 In the small open economy, the interest rate

on these loans is given by the world real interest rate During the sudden stop, an increase

in interest rates, through its effects on the purchase of intermediate goods, will increase thecost of production

A representative consumer supplies labor and rents capital to each sector, demandsfinal goods, invests in capital goods, and borrows or lends from abroad at the world interestrate At each period, all factor and goods markets clear The price of the final good is thenumeraire We now describe this economy in detail

Consumers The representative consumer is endowed with one unit of labor which is plied inelastically.14 Each period, the consumer consumes the final good Ct, saves/borrows

sup-in foreign bonds Bt+1 valued at the price of traded goods pT

t, and invests in capital Kt+1.The consumers problem can be written as

max

C t ,K t+1 ,B t+1

∞

t=0

14 Since our main interest is understanding the movements in TFP and their contribution to a fall in output, we abstract from variations in factor use as an explanation for a fall in GDP.

subject to the budget constraint

Kt

2

The rental rate on capital is rt, and the depreciation rate is δ The interest rate on bonds isgiven by r∗

t.The intertemporal costs of adjustment of capital are governed by the parameter

ψK and β is the discount factor

Final Goods Producers The final good is used for consumption and investment and isproduced using the non-tradable good QN

t and the tradable good QT

t Each period, theproducer of the final good solves the following problem

The price of the final good is the numeraire

Traded and Non traded Goods Producers Traded and non traded goods are produceddomestically by representative firms in each sector i = T, N with a Cobb Douglas productionfunction

using capital, labor Li

t and intermediate goods Mi

t.Production in this sector is subject to the working capital constraint mentioned earlier

A fraction κ of the purchase of intermediate goods needs to be financed by within periodloans, at an interest rate rt+1 Hence the firm’s problem in the ith sector (i = T, N) can bewritten as

or equivalently,

max

K i ,L i ,M ipitYti − wtLit− rtKti− pMt Mtiwhere

the interest rate r∗

t+1, repayable next period The firms repay the intermediary the amount(1 + rt+1) κpM

t Mtwithin the same period t The intermediary stores this amount, converts it

to traded goods at time t + 1, and returns it to the foreign lender The zero profit conditionfor the intermediaries implies that their costs of funds must equal the amount received fromfirms In other words

1 + r∗ t+1

rt+1 =

1 + r∗ t+1

T t+1

pT t

− 1

In what follows, we will find it convenient to define the gross real interest rate as

Rt+1 =

1 + r∗ t+1

T t+1

pT t

Equilibrium The market clearing conditions for this model are:

(i) for the final good

The last two terms are included because they represent the amount of final good which thefinancial intermediary stores today less the amount stored from the previous period, which

is needed for the repayment of the loans of the last period

(ii) for tradable and non-tradable goods

QTt + MtT + NXt = YtT

QNt + MtN = YtN

where NXt are net exports

(iii) for intermediate goods

MtT + MN

t = Mtand

(iv) for capital and labor

KtT + KN

t = Kt

LTt + LN

Macroeconomic Aggregates GDP in this economy can be expressed as



pM

t − pM

t Mt.The current account balance can be derived by noting that the budget constraint ofthe consumer

3.1 Calibration

We calibrate the model to match key features of the Mexican economy on the eve of thecrisis To quantify the interactions between sectors, we use the input output tables reported

in Kehoe and Ruhl (2009)

Production Function Parameters For the traded goods sector the following two ratiossuffice to identify production function parameters

(1 − αT) εT

εT = 0.521

These two equations give us the values for εT = 0.475 and αT = 0.479

Similarly for the non traded goods sector

pro-pT

tMT t

pN

t MN t

1 − φ.The counterpart to this in the input output tables is

Traded Goods Used as IntermediatesNon Traded Goods Used as Intermediates = 1.243,

which results in a value of φ = 0.554.

Financial Constraint The fraction of intermediate goods that need to be bought oncredit κ, is a key parameter of the model, since it governs the size of the wedge between theproducer and user cost of intermediate goods This is calibrated using a combination of firmlevel data and macro data κ can be decomposed as

κ = Intermediate goods bought on credit

Intermediate Goods

=

Intermediate Goods bought on credit

Output



×

Total OutputIntermediate Goods



The numerator of the first term is hard to estimate However, from firm level data we have

a measure of short term debt liabilities Using this data for the numerator and the sum oftotal sales and inventories for the denominator gives us the first ratio.15 The second ratiocomes from the NIPA data and is the ratio of gross output to total intermediate goods Theproduct of these ratios gives us a value of κ = 0.7 This is lower than the value of κ = 1used in Neumeyer and Perri (2005) and Uribe and Yue (2006) However, it is higher thanthe 10 percent value used in Mendoza and Yue (2009), who calibrate it to the volatility ofthe trade balance We experiment with a range of values to explore the sensitivity of ourresults to this parameter.16

Utility Function and Final Good Production Parameters We set σ = 2, which isconsistent with an intertemporal elasticity of substitution of consumption of 0.5 FollowingKehoe and Ruhl (2009) and Stockman and Tesar (1995) we set ρ = −1, consistent with anelasticity of substitution between traded and non traded goods of 0.5 To get γ note thatthe first order conditions from the final goods producer problem imply that

Relative to a base price ratio, we can identify γ from the ratio of traded goods to non tradedgoods used in the production of final goods Since final goods in our model are used forconsumption and investment, we use the input output table to get

Outside the crisis, the interest rate r∗

is set to 5%, consistent with average world realinterest rates The consumer’s discount factor β is set to 1

1+r ∗

Parameters calibrated to the steady state The parameters that remain to be terised are the scale parameters AT, AN and AM We also need to specify the initial stock

charac-of assets B0 and the adjustment costs of capital ψK

We compute a steady state equilibrium for the model economy, and calibrate the values

of AT and AM and B0 relative to AN, which is set to 1 The goal is to jointly match threetargets, the share of labor in the traded goods sector, the investment to output ratio and thetrade balance in 1994 While we do not claim that the Mexican economy was in a steadystate in 1994, given the appreciating real exchange rate, declining interest rates and theincreasing share of the non traded goods sector in the economy over the five previous years,calibrating to a steady state or transition is irrelevant for our purposes, except as a means

to get initial conditions for the experiment We also check the sensitivity of our results tothese initial conditions

Finally, the adjustment cost parameter ψK is calibrated to match the the investment toGDP ratio in 1995 The parameters calibrated and the statistics they match are summarized

in Table 2

To understand how the economy performs after a sudden stop, we perform the followingexperiment Beginning from a steady state calibrated to match key features of the Mexicaneconomy in 1994, as described in the previous section, we increase the interest rate, r∗

t+1

Table 2: Calibrated Parameters

Ratio of intermediates to T sector value added 1.103 εT 0.475

Ratio of intermediates to N sector value added 0.438 εN 0.696

TFP and Output Effects As interest rates increase, the wedge between the producerprice and the user price of intermediate goods increases In our model this is measured as

pT tNotice that the increase in the wedge comes from two sources: first the increase in the interestrate itself, and second from the increase in the price of traded goods, as a result of increasedsavings In Appendix B we show analytically, in the context of a simplified model, how

17 Notice that this is not a very important assumption in our model since in the model agents have limited ability to hedge against the interest rate shock As Meza and Quintin (2008) and Pratap and Quintin (2010) show, the only difference between a perfect foresight and a perfect surprise scenario is that in the former the capital output ratio in the economy, counterfactually, falls before the shock.

Net Exports to GDP Ratio

-0.2 -0.1 0.0 0.1 0.2 0.3

Figure 4: Aggregates in the Baseline Modelchanges in interest rate map into changes in TFP when a financial friction for the purchase

of intermediates is present

The top two panels of figure 4 show that the resulting fall in aggregate TFP and output

is 3.5 percent, accounting for 52 percent of the observed decline in TFP and 74 percent ofoutput per worker in the data.18 Since our model does not admit a role for variations inlabor supply, which account for about one third of the decline in GDP in the data (as seen

in Table 1), we compare its predictions to macroeconomic aggregates per worker

The Real Exchange Rate and Current Account Since the economy saves in tradedgoods, the demand for traded goods also goes up as interest rates increase, putting upwardpressure on the relative price of the traded good The lower left panel of Figure 4 shows the

18 Variables in the data are detrended following the same procedure as in Section 2.

model predicted relative price ratio, compared to that in the data The model predicts anincrease of 9.8 percent, as compared to 8 percent observed in the data This is short of the

55 percent depreciation of the real exchange rate observed in the data, which is expectedsince our model does not allow for deviations in the law of one price for traded goods Asinterest rates come back to their pre-crisis level, the real exchange rate also returns to its

1994 levels In the data the return was much more gradual

In addition, the model predicts a current account reversal as the lower right panel inFigure 4 shows, although it overpredicts the magnitude of the changes From a deficit ofabout 5 percent the current account to GDP ratio increased to a surplus of about 4 percent

in the data and about 10 percent in the model As the interest rate returns to normal, thetrade balance deteriorates, again, at a faster rate in the model than in the data

Sectoral Output and the Intersectoral Reallocation of Resources Thus far themodel has performed remarkably well in explaining the behavior of macroeconomic aggre-gates following the sudden stop This aggregate picture however, obscures discrepancies atthe sectoral level The top two panels of figure 5 show the model predicted and the actual(detrended) GDP per worker in the traded and non traded goods sector respectively As thefigures make clear, the baseline model contradicts the data in some important dimensions.The model predicts an increase in the output per worker of the traded goods sector

of almost 10 percent, whereas in the data it declined by about 1.6 percent It also greatlyover-predicts the decline in the non traded goods sector The middle panels show the fall inTFP in each sector generated by the model Contrary to the data, the model predicts thatTFP fell by much more in the traded goods sector Despite this fall in TFP, output in thetraded goods sector increases due to a large reallocation of labor and capital from the nontraded to the traded goods sector, following the real depreciation However the data doesnot support the reallocation of productive factors implied by the model

Clearly if our model is to match the sectoral data, we need to understand the frictionsthat impede the reallocation of factors of production We introduce such frictions in thefollowing section

1994 1995 1996 1997 1998 1999 2000

Year TFP in the T Sector

1994 1995 1996 1997 1998 1999 2000

Figure 5: Sectoral Patterns in the Baseline Model

4 Model with Reallocation Frictions

We introduce two frictions into the baseline model First, a labor adjustment cost is incurred

if labor moves from one sector to another For analytical convenience, we assume that thiscost is borne by the consumer.19 Second, we assume that capital is completely sector specificand can be augmented only by new investment in that particular sector

The representative consumer chooses consumption, Ct, savings Bt+1, capital stock ineach sector KT

t+1 and KN

t+1,and the fraction of their labor endowment to be supplied to thetraded goods sector θt, to maximize the discounted stream of their lifetime utility subject tothe budget constraint:

t

KT t

2

− ψK2



KN t+1− KN

t

KN t

Note that the labor market friction and the capital specificity imply that factor prices

do not equate across each sector and are now sector specific as well As documented inMeza and Urrutia (2010), changes in the relative wage of workers in the traded and non-traded goods sectors have been important in Mexico during the 1988-2002 period, reflectingsystematic deviations from sectoral wage equalization

19 Pratap and Quintin (2010) show that workers who change occupations during the crisis in Mexico saw their wages fall by about 10% more than those who did not move, even after controlling for observed and