Total factor productivity and labor reallocation: the case of the 1997 Korea crisis

Detrended Total Factor Productivity (TFP), net of changes in capital utilization, fell by 3.3% after the Korean 1997 financial crisis. Detrended real GDP per working age person fell by 11.9%. We construct a two-sector small open economy model that can account for 30.0% of the fall in TFP in response to a sudden stop of capital inflows and an increase in international interest rates. Empirically, the fall in TFP follows a reallocation of labor from the more productive manufacturing sector to the less productive agriculture and public sectors. The model has a consumption sector and an investment sector. The reallocation of labor in the data corresponds to a movement from the investment sector to the consumption sector in the model. In the model, a sudden stop raises the costs of imports, which are used more heavily as an input in the investment sector. Also investment falls sharply in response to the increase in international interest rates. We show further that a fall in export demand and working capital requirements can both amplify the effects of the sudden stop. The model accounts for 41.0% of the fall in GDP.