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Regime Switching Interest Rates and Fluctuations in Emerging Markets

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  • Bertrand Gruss
  • Karel Mertens

Abstract

We estimate regime switching models for emerging market interest rates and embed the obtained nonlinear dynamics in a small open economy model with a financial friction. We show that the presence of an infrequent regime characterized by high level/high volatility of interest rates and the tightening of financial constraints is key to account for the empirical regularities specific to emerging markets, including the high volatility of consumption relative to output and a strongly countercyclical trade balance-to-output ratio. The model accounts for the dynamics of sudden stops and matches the autocorrelation function of the trade balance-to-output ratio as well as the cross-correlations between the main macroeconomic aggregates and interest rates. Our findings suggest that interest rate shocks and financial frictions are essential for explaining emerging market fluctuations, but mostly because of their effects in crisis episodes.

Suggested Citation

  • Bertrand Gruss & Karel Mertens, 2009. "Regime Switching Interest Rates and Fluctuations in Emerging Markets," Economics Working Papers ECO2009/22, European University Institute.
  • Handle: RePEc:eui:euiwps:eco2009/22
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    References listed on IDEAS

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    Cited by:

    1. International Monetary Fund, 2011. "Business Cycles in Emerging Markets; The Role of Durable Goods and Financial Frictions," IMF Working Papers 11/133, International Monetary Fund.
    2. Hernan Seoane, 2016. "Time-varying volatility, default and the sovereign risk premium," 2016 Meeting Papers 1132, Society for Economic Dynamics.
    3. Álvarez-Parra, Fernando & Brandao-Marques, Luis & Toledo, Manuel, 2013. "Durable goods, financial frictions, and business cycles in emerging economies," Journal of Monetary Economics, Elsevier, vol. 60(6), pages 720-736.

    More about this item

    Keywords

    regime switching model; peso problem; sudden stops; small open economy;

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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