Modelling Sudden Stops: The non-trivial role of preference specications

Recent international macroeconomics literature on sudden stops faces a puzzling ambiguity. Using essentially the same basic small, open economy model with collateral constraints, some studies successfully predict the empirically observed link between sudden stops and output drops, while others get the opposite result where sudden stops lead to increases in output. In this paper we resolve this ambiguity and theoretically prove that the ambiguity results from choice of preference speci…cations. Specifically, using quasi-linear or GHH preferences allows a small, open economy model to yield observations consistent with data . In contrast, using standard Cobb-Douglas preferences as in business cycle literature leads to an increase in output in response to sudden stop. Keywords: Sudden Stops, General Equilibrium, Borrowing Constraints, Preference Speci…cations, Wealth E¤ects (JEL Classi…cation Code: F41; F32; E44; D52)