Financial frictions and total factor productivity: Accounting for the real effects of financial crises

Financial crises in emerging economies are accompanied by a large fall in total factor productivity. We explore the role of financial frictions in exacerbating the misallocation of resources and explaining this drop in TFP. We build a two-sector model of a small open economy with a working capital constraint on the purchase of intermediate goods. The model is calibrated to Mexico before the 1995 crisis and subjected to an unexpected shock to interest rates. The financial friction generates an endogenous fall in TFP and output and can explain more than half of the fall in TFP and 74 percent of the fall in GDP per worker.

► Financial crises are typically accompanied by a big drop in total factor productivity.
► Can financial frictions explain the drop in TFP in an economy with a working capital constraint?
► The constraint generates a fall in TFP when interest rates increase to 1994 crisis levels in Mexico.
► The model explains 52 percent of the fall in TFP and 74 percent of the fall in GDP per worker observed in the data.