Financial Frections and Business Cycles in Middle Income Countries

Standard DSGE small open economy models can not generate the cyclical properties of middleincome countries (MICs). These models, compared to the data, predict excessive consumption smoothing, low procyclicality of investment and procyclical, instead of counter cyclical, real net exports. Previous studies have solved this problem by increasing the persistence of shocks or by lowering the intertemporal elasticity of substitution. This paper tackles it by introducing market imperfections relevant for MICs into an otherwise standard model. More specifically, we build a model with limited access to the foreign capital market, identified as an external borrowing constraint, and asymmetric financing opportunities across tradable and non-tradable sectors, identified as sector-specific labor financing wedges. The key parameters associated to these frictions are deduced to replicate selected data for Chile between 1986 and 2004. We find that the external borrowing constraint makes investment and consumption of tradable goods more procyclical and volatile, making real net exports counter cyclical. However, it produces counter cyclical employment and a low volatility of consumption of non tradable. Introducing sectorspecific labor financing wedges enables the model to reproduce these moments as well.