Total Factor Productivity and Labor Reallocation: The Case of the Korean 1997 Crisis

Detrended Total Factor Productivity (TFP), net of changes in capital utilization, fell by 3.3% after the Korean 1997 financial crisis. We construct a small open economy model that accounts for 30.0% of the fall 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 and an investment sector. The reallocation of labor in the data corresponds to a reallocation from the investment sector to the consumption sector. In the model, a sudden stop raises the costs of imports, which are used as an input in the investment sector. Investment falls sharply in response to the increase in interest rates. A fall in export demand and working capital requirements amplify the effects of the sudden stop.