Trade Openness and the Cost of Sudden Stops: The Role of Financial Friction

This paper studies the long-run welfare effect of the extra volatility of country spread due to the possibility of sudden stops. Both analytical and numerical results show that sudden stops have weaker output impact when the small open economy is more open to trade. However, welfare consequences and policy implication of sudden stops depend on the financial friction faced by the small open economy. When it is free to adjust foreign debt, the cost of sudden stops is decreasing in trade openness, which implies the optimality of open trade policy. In this case, external shocks may be welfare improving. In addition, the economy will gain from counter-cyclical tariff rate policies. On the other hand, when it is costly to adjust foreign debt, the cost of sudden stops may be increasing in trade openness, which implies the optimality of a closed trade policy. In this case, the nature of the policy and how the government implements the policy matter. The results hold in economies with and without the working capital constraint, and in economies with GHH preferences and Cobb-Douglas preferences.