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Liquidity Contraints and Business Cycles in Developing Economies

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  • Benoît Carmichael

    (Département d'Économique, Université Laval)

  • Sikoro Keita

    (USAID/Mali Results Center)

  • Lucie Samson

    (Département d'Économique, Université Laval)

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    Abstract

    Open economy extensions of real business cycle models, even if generally successful, have met some difficulties replicating a few important stylized facts. In particular these models tend to predict excessive consumption smoothing and consumption correlation across countries. The observed negative correlation between the trade balance and output in developing countries, the variability of the trade balance and its correlation with the terms of trade have also proven difficult to reproduce. The paper considers how introduction of incomplete markets in the form of liquidity constraints can alleviate these problems. This analysis suggests that adding liquidity constraints helps predict the variability of consumption relative to output. It also improves our estimate of the correlation between the trade balance and output. The model correctly replicates the small positive correlation between the terms of trade and the trade balance. However, it slightly underpredicts the variability of the trade balance when fifty percent of the consumers are assumed to be liquidity constrained. (Copyright: Elsevier)

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    Bibliographic Info

    Article provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.

    Volume (Year): 2 (1999)
    Issue (Month): 2 (April)
    Pages: 370-402

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    Handle: RePEc:red:issued:v:2:y:1999:i:2:p:370-402

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    Related research

    Keywords: financial constraints; developing economy; business cycles;

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    References

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    1. A. Senhadji Semlali, 1997. "Sources of Debt Accumulation in a Small Open Economy," IMF Working Papers, International Monetary Fund 97/146, International Monetary Fund.
    2. Edward C. Prescott, 1986. "Theory ahead of business cycle measurement," Quarterly Review, Federal Reserve Bank of Minneapolis, Federal Reserve Bank of Minneapolis, issue Fall, pages 9-22.
    3. Jean-Pierre DANTHINE & John B. DONALDSON & Rajnish MEHRA, 1992. "The Equity Premium and the Allocation of Income Risk," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP), Université de Lausanne, Faculté des HEC, DEEP 9203, Université de Lausanne, Faculté des HEC, DEEP.
    4. Greenwood, Jeremy & Hercowitz, Zvi & Huffman, Gregory W, 1988. "Investment, Capacity Utilization, and the Real Business Cycle," American Economic Review, American Economic Association, American Economic Association, vol. 78(3), pages 402-17, June.
    5. Reinhart, Carmen & Ostry, Jonathan, 1991. "Private Saving and Terms of Trade Shocks," MPRA Paper 13716, University Library of Munich, Germany.
    6. Blanchard, Olivier J, 1985. "Debt, Deficits, and Finite Horizons," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 93(2), pages 223-47, April.
    7. Michael A. Kouparitsas, 1996. "North-South financial integration and business cycles," Working Paper Series, Macroeconomic Issues, Federal Reserve Bank of Chicago WP-96-10, Federal Reserve Bank of Chicago.
    8. Reinhart, Carmen & Ostry, Jonathan, 1992. "Saving and Terms of Trade Shocks: Evidence from Developing Countries," MPRA Paper 6976, University Library of Munich, Germany.
    9. Richard Black & David Rose, 1997. "Canadian Policy Analysis Model: CPAM," Working Papers, Bank of Canada 97-16, Bank of Canada.
    10. Enrique G. Mendoza, 1992. "The Effects of Macroeconomic Shocks in a Basic Equilibrium Framework," IMF Staff Papers, Palgrave Macmillan, vol. 39(4), pages 855-889, December.
    11. Jonathan D. Ostry & Carmen M. Reinhart, 1992. "Private Saving and Terms of Trade Shocks: Evidence from Developing Countries," IMF Staff Papers, Palgrave Macmillan, vol. 39(3), pages 495-517, September.
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    Cited by:
    1. Kalulumia, Pene & Nyankiye, Francine, 2000. "Labor Adjustment Costs, Macroeconomic Shocks and Real Business Cycles in a Small Open Economy," Journal of Macroeconomics, Elsevier, Elsevier, vol. 22(4), pages 671-694, October.

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