Sudden Stops, Productivity, and the Exchange Rate

Following a sudden stop, real exchange rates adjust through a nominal depreciation, lower domestic prices, or both. This paper studies how the nature of that adjustment shapes the productivity response. Using Spanish manufacturing microdata, it shows that, in a currency union, cleansing through firm exit is stronger than under a floating regime, with aggregate productivity rising despite weaker firm-level performance. A small open economy DSGE model with firm dynamics, endogenous markups, and nominal rigidities rationalizes this finding. The model identifies three channels through which a sudden stop affects productivity: pro-competitive, cost, and demand. While only the first operates under a floating regime, all three are active in a currency union. Quantitatively, the model explains about 60% of the exit-driven contribution to productivity growth in Spain’s 2010–13 episode. Cross-country evidence confirms that the fall in productivity during sudden stops is systematically larger when exchange rates are more flexible.