Reassessing the role of trend shocks in emerging-market business cycles

This paper reassesses the role of trend shocks in emerging-market business cycles by integrating all previously studied financial frictions within a unified, estimated SOE-RBC model. Focusing on Korea (with Mexico as a benchmark), the model features transitory and trend productivity shocks, a world interest-rate shock, and three financial frictions: a debt-elastic country spread, an expected-productivity premium, and a working-capital requirement. Using Korean quarterly data (1994Q1–2012Q4), reduced-form evidence shows that consumption in Korea responds more strongly to output than in Mexico and that the spread is governed by both debt and expected productivity, whereas in Mexico it is driven only by debt. Joint GMM estimation of the structural model and counterfactuals indicates a dominant trend component: trend shocks account for about 82% of TFP-growth variance and roughly 66% of output volatility and 76% of consumption volatility, whereas fluctuations in Mexico are chiefly transitory. Removing financial frictions eliminates countercyclical interest-rate and trade-balance behavior, lowers output volatility, and raises consumption volatility; restoring only the expected-productivity premium largely reinstates countercyclicality, while the debt-elastic channel is key for output amplification. The working-capital parameter is negligible.