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Business Cycles in Small Developed Economies; The Role of Terms of Trade and Foreign Interest Rate Shocks

  • Jaime Guajardo
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    Empirical evidence for small developed economies finds that consumption is procyclical and as volatile as output, and real net exports are coutercyclical. Earlier studies have not been able to reproduce these regularities in a DSGE small open economy model when productivity shocks drive the business cycles and households have a normal intertemporal elasticity of substitution. Instead, these studies have reduced this elasticity to make consumption more procyclical and volatile and real net exports countercyclical. This paper shows that a standard model can reproduce these regularities, without lowering the intertemporal substitution, if the terms of trade and foreign interest rate are added as source of business cycle fluctuations. These shocks, compared to productivity shocks, make consumption and investment more volatile and procyclical relative to output, and make real net exports countercyclical.

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    Paper provided by International Monetary Fund in its series IMF Working Papers with number 08/86.

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    Length: 25
    Date of creation: 01 Apr 2008
    Date of revision:
    Handle: RePEc:imf:imfwpa:08/86
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    1. David K. Backus & Patrick J. Kehoe, 1991. "International evidence on the historical properties of business cycles," Staff Report 145, Federal Reserve Bank of Minneapolis.
    2. David K. Backus & Patrick J. Kehoe & Finn E. Kydland, 1987. "International real business cycles," Working Papers 426, Federal Reserve Bank of Minneapolis.
    3. Alan C. Stockman & Linda L. Tesar, 1991. "Tastes and technology in a two-country model of the business cycle: explaining international co-movements," Working Paper 9019, Federal Reserve Bank of Cleveland.
    4. Mark Aguiar & Gita Gopinath, 2007. "Emerging Market Business Cycles: The Cycle Is the Trend," Journal of Political Economy, University of Chicago Press, vol. 115, pages 69-102.
    5. Andrea Raffo, 2006. "Net exports, consumption volatility, and international real business cycle models," Research Working Paper RWP 06-01, Federal Reserve Bank of Kansas City.
    6. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Closing Small Open Economy Models," Departmental Working Papers 200115, Rutgers University, Department of Economics.
    7. Pablo A. Neumeyer & Fabrizio Perri, 2004. "Business cycles in emerging economies: the role of interest rates," Staff Report 335, Federal Reserve Bank of Minneapolis.
    8. Baxter, Marianne & Crucini, Mario J, 1995. "Business Cycles and the Asset Structure of Foreign Trade," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 36(4), pages 821-54, November.
    9. Greenwood, Jeremy & Hercowitz, Zvi & Huffman, Gregory W, 1988. "Investment, Capacity Utilization, and the Real Business Cycle," American Economic Review, American Economic Association, vol. 78(3), pages 402-17, June.
    10. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
    11. Correia, Isabel & Neves, Joao C. & Rebelo, Sergio, 1995. "Business cycles in a small open economy," European Economic Review, Elsevier, vol. 39(6), pages 1089-1113, June.
    12. Aguiar, Mark & Gopinath, Gita, 2007. "Emerging Market Business Cycles: The Cycle is the Trend," Scholarly Articles 11988098, Harvard University Department of Economics.
    13. Mendoza, Enrique G, 1991. "Real Business Cycles in a Small Open Economy," American Economic Review, American Economic Association, vol. 81(4), pages 797-818, September.
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