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Financial Frections and Business Cycles in Middle Income Countries

  • Jaime C. Guajardo
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    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.

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    Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 444.

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    Date of creation: Dec 2007
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    Handle: RePEc:chb:bcchwp:444
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    1. Narayana Kocherlakota, 2010. "Implications of Efficient Risk Sharing Without Commitment," Levine's Working Paper Archive 2053, David K. Levine.
    2. Rómulo A. Chumacero & Klaus Schmidt-Hebbel, 2004. "General Equilibrium Models: An Overview," Working Papers Central Bank of Chile 307, Central Bank of Chile.
    3. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Wiley Blackwell, vol. 48(2), pages 289-309, April.
    4. Rui Albuquerque & Hugo A. Hopenhayn, 2004. "Optimal Lending Contracts and Firm Dynamics," Review of Economic Studies, Wiley Blackwell, vol. 71(2), pages 285-315, 04.
    5. Bengt Holmstrom & Jean Tirole, 1996. "Private and Public Supply of Liquidity," NBER Working Papers 5817, National Bureau of Economic Research, Inc.
    6. Stephanie Schmitt-Grohe & Martin Uribe, 2002. "Closing Small Open Economy Models," NBER Working Papers 9270, National Bureau of Economic Research, Inc.
    7. Juan Pablo Medina, 2004. "Endogenous Financial Constraints: Persistence and Interest Rate Fluctuations," Working Papers Central Bank of Chile 290, Central Bank of Chile.
    8. Andrew Atkeson & Jose-Victor Rios-Rull, 1995. "The Balance of Payments and Borrowing Constraints: An Alternative View of the Mexican Crisis," NBER Working Papers 5329, National Bureau of Economic Research, Inc.
    9. Alan C. Stockman & Linda L. Tesar, 1990. "Tastes and Technology in a Two-Country Model of the Business Cycle: Explaining International Comovements," NBER Working Papers 3566, National Bureau of Economic Research, Inc.
    10. Atkeson, Andrew, 1991. "International Lending with Moral Hazard and Risk of Repudiation," Econometrica, Econometric Society, vol. 59(4), pages 1069-89, July.
    11. Domeij, David & Floden, Martin, 2001. "The labor-supply elasticity and borrowing constraints: Why estimates are biased," SSE/EFI Working Paper Series in Economics and Finance 480, Stockholm School of Economics.
    12. Francisco Gallego & Klaus Schmidt-Hebbel & Luis Servén, 2005. "General Equilibrium Dynamics of Foreign Shocks ans Policy Changes in Chile," Central Banking, Analysis, and Economic Policies Book Series, in: Rómulo A. Chumacero & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (S (ed.), General Equilibrium Models for the Chilean Economy, edition 1, volume 9, chapter 4, pages 113-162 Central Bank of Chile.
    13. Correia, Isabel & Neves, Joao C & Rebelo, Sérgio, 1994. "Business Cycles in a Small Open Economy," CEPR Discussion Papers 996, C.E.P.R. Discussion Papers.
    14. Rui Albuquerque & Hugo A. Hopenhayn, 2004. "Optimal Lending Contracts and Firm Dynamics," Review of Economic Studies, Oxford University Press, vol. 71(2), pages 285-315.
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