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World Interest Rate, Business Cycles, and Financial Intermediation in Small Open Economies

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  • Oviedo, P. Marcelo

Abstract

The consensus about the ability of the standard open-economy neoclassical growth model to account for interest-rate driven business cycles has changed over time: whereas early research concluded that business cycles are neutral to interest-rate shocks, more recent investigations suggest that these shocks can explain a large extent of the business cycles of a small open economy when firms borrow to pay for their labor cost before cashing their sales. The first goal of this paper is to show that the recently found effectiveness of interest-rate shocks to cause business cycles rests more on the statistical properties of the shocks than on the working-capital constraint; in particular, recent results are only valid when the level and volatility of the interest rate are high and when the interest rate is negatively correlated with total factor productivity. The paper also shows that interest-rate shocks cannot be the sole driving force of business cycles even when the canonical model is augmented to include a working-capital constraint. The second goal of the paper is to quantitatively explore the dynamic properties of the neoclassical growth model extended to include financial intermediation. It is shown that the extended model with external effects in financial intermediation can match the negative correlation between GDP and a domestic borrowing-lending spread in emerging countries if the economy is subject to productivity shocks but not when the model is subject to both productivity and interest-rate shocks.

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Bibliographic Info

Paper provided by Iowa State University, Department of Economics in its series Staff General Research Papers with number 12360.

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Date of creation: 17 May 2005
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Handle: RePEc:isu:genres:12360

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Postal: Iowa State University, Dept. of Economics, 260 Heady Hall, Ames, IA 50011-1070
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Fax: +1 515.294.0221
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Web page: http://www.econ.iastate.edu
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Keywords: financial intermediation; open-economy business cycles; interest rates; capital inflows;

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References

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  1. Pablo A. Neumeyer & Fabrizio Perri, 2004. "Business Cycles in Emerging Economies: The Role of Interest Rates," NBER Working Papers 10387, National Bureau of Economic Research, Inc.
  2. Cristina Arellano & Enrique G. Mendoza, 2002. "Credit Frictions and 'Sudden Stops' in Small Open Economies: An Equilibrium Business Cycle Framework for Emerging Markets Crises," NBER Working Papers 8880, National Bureau of Economic Research, Inc.
  3. Agenor, Pierre-Richard & McDermott, C John & Prasad, Eswar S, 2000. "Macroeconomic Fluctuations in Developing Countries: Some Stylized Facts," World Bank Economic Review, World Bank Group, vol. 14(2), pages 251-85, May.
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  5. Danthine, Jean-Pierre & Donaldson, John B. & Mehra, Rajnish, 1989. "On some computational aspects of equilibrium business cycle theory," Journal of Economic Dynamics and Control, Elsevier, vol. 13(3), pages 449-470, July.
  6. Benston, George J & Smith, Clifford W, Jr, 1976. "A Transactions Cost Approach to the Theory of Financial Intermediation," Journal of Finance, American Finance Association, vol. 31(2), pages 215-31, May.
  7. Correia, Maria Isabel Horta & Neves, Joao C & Rebelo, Sérgio, 1994. "Business Cycles in a Small Open Economy," CEPR Discussion Papers 996, C.E.P.R. Discussion Papers.
  8. Martin Uribe & Vivian Yue, 2004. "Country spreads and emerging countries: who drives whom?," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  9. Xavier Freixas & Jean-Charles Rochet, 1997. "Microeconomics of Banking," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061937, December.
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  11. Stephanie Schmitt-Grohe & Martin Uribe, 2002. "Closing Small Open Economy Models," NBER Working Papers 9270, National Bureau of Economic Research, Inc.
  12. Fabio Kanczuk, 2004. "Real Interest Rates and Brazilian Business Cycles," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 7(2), pages 436-455, April.
  13. den Haan, Wouter J & Marcet, Albert, 1990. "Solving the Stochastic Growth Model by Parameterizing Expectations," Journal of Business & Economic Statistics, American Statistical Association, vol. 8(1), pages 31-34, January.
  14. Oviedo, P. Marcelo, 2009. "A Toolbox for the Study of Linear Difference Rational Expectations Models," Staff General Research Papers 12925, Iowa State University, Department of Economics.
  15. Carmen M. Reinhart & Vincent Raymond Reinhart, 2002. "What Hurts Emerging Markets Most? G3 Exchange Rate or Interest Rate Volatility?," NBER Chapters, in: Preventing Currency Crises in Emerging Markets, pages 133-170 National Bureau of Economic Research, Inc.
  16. Epstein, Larry G., 1983. "Stationary cardinal utility and optimal growth under uncertainty," Journal of Economic Theory, Elsevier, vol. 31(1), pages 133-152, October.
  17. Lawrence J. Christiano, 1991. "Modeling the liquidity effect of a money shock," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 3-34.
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