Financial Frictions and Business Cycles in Developing Countries

Standard theory of small open economies predicts a smooth path for consumption and investment over time, and procyclical current account balances and employment. This contrasts with the data for emerging countries, where consumption, investment and employment are highly procyclical and volatile, and the current account balance is counter cyclical. Previous studies have reconciled theory and data using different households preferences for emerging countries vs. developed ones, either a lower intertemporal elasticity of substitution or the use of GHH type of preferences. This paper takes a different approach. It explores whether adding two financial frictions to an otherwise standard small open economy model, an external borrowing constraint and labor financing wedges, can reconcile theory and data without appealing to changes in preferences, but rather to market imperfections widely studied in the literature for the emerging world. I find that adding the external borrowing constraint makes consumption and investment more procyclical and volatile, and reproduces the counter cyclical path of the current account. However, it generates counter cyclical employment. Adding the labor financing wedges reproduces the cyclical path of this variable as well