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World Interest Rate, Business Cycles, and Financial Intermediation in Small Open Economies

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  • Oviedo, P. Marcelo

Abstract

The consensus about the ability of the standard open-economy neoclassical growth model to account for interest-rate driven business cycles has changed over time: whereas early research concluded that business cycles are neutral to interest-rate shocks, more recent investigations suggest that these shocks can explain a large extent of the business cycles of a small open economy when firms borrow to pay for their labor cost before cashing their sales. The first goal of this paper is to show that the recently found effectiveness of interest-rate shocks to cause business cycles rests more on the statistical properties of the shocks than on the working-capital constraint; in particular, recent results are only valid when the level and volatility of the interest rate are high and when the interest rate is negatively correlated with total factor productivity. The paper also shows that interest-rate shocks cannot be the sole driving force of business cycles even when the canonical model is augmented to include a working-capital constraint. The second goal of the paper is to quantitatively explore the dynamic properties of the neoclassical growth model extended to include financial intermediation. It is shown that the extended model with external effects in financial intermediation can match the negative correlation between GDP and a domestic borrowing-lending spread in emerging countries if the economy is subject to productivity shocks but not when the model is subject to both productivity and interest-rate shocks.

Suggested Citation

  • Oviedo, P. Marcelo, 2005. "World Interest Rate, Business Cycles, and Financial Intermediation in Small Open Economies," Staff General Research Papers Archive 12360, Iowa State University, Department of Economics.
  • Handle: RePEc:isu:genres:12360
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    File URL: http://www2.econ.iastate.edu/papers/p3913-2005-05-17.pdf
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    References listed on IDEAS

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    Cited by:

    1. Jessica Roldan-Pena, 2011. "Default risk and economic activity: A small open economy model with sovereign debt and default," 2011 Meeting Papers 735, Society for Economic Dynamics.
    2. Taştan, Hüseyin, 2013. "Real business cycles in emerging economies: Turkish case," Economic Modelling, Elsevier, vol. 34(C), pages 106-113.
    3. Akıncı, Özge, 2013. "Global financial conditions, country spreads and macroeconomic fluctuations in emerging countries," Journal of International Economics, Elsevier, vol. 91(2), pages 358-371.
    4. Durdu, Ceyhun Bora, 2009. "Quantitative implications of indexed bonds in small open economies," Journal of Economic Dynamics and Control, Elsevier, vol. 33(4), pages 883-902, April.
    5. Echeverria Garaigorta, Paulina Elisa & Iza Padilla, María Amaya, 2011. "Business cycles in a small open economy: The case of Hong Kong," DFAEII Working Papers 2011-07, University of the Basque Country - Department of Foundations of Economic Analysis II.
    6. Roberto Chang & Andrés Fernández, 2013. "On The Sources Of Aggregate Fluctuations In Emerging Economies," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 54, pages 1265-1293, November.
    7. Varela, Liliana, 2017. "Sector heterogeneity and credit market imperfections in emerging markets," Journal of International Money and Finance, Elsevier, vol. 70(C), pages 433-451.
    8. Juan David Prada Sarmiento, 2008. "Financial Intermediation and Monetary Policy in a Small Open Economy," Borradores de Economia 531, Banco de la Republica de Colombia.
    9. Emine Boz & Christian Daude & Ceyhun Bora Durdu, 2008. "Emerging market business cycles revisited: learning about the trend," International Finance Discussion Papers 927, Board of Governors of the Federal Reserve System (U.S.).
    10. Enrique G. Mendoza, 2006. "Lessons from the Debt-Deflation Theory of Sudden Stops," American Economic Review, American Economic Association, vol. 96(2), pages 411-416, May.
    11. Jacek Rothert, 2012. "Productivity or Demand? Identifying Sources of Fluctuations in Small Open Economies," 2012 Meeting Papers 187, Society for Economic Dynamics.
    12. Roberto Duncan, 2015. "Simple Models to Understand and Teach Business Cycle Macroeconomics for Emerging Market and Developing Economies," Working Papers 2015-49, Peruvian Economic Association.
    13. Adam Gulan & Andres Fernandez, 2012. "Interest Rates and Business Cycles in Emerging Economies.The Role of Financial Frictions," 2012 Meeting Papers 849, Society for Economic Dynamics.
    14. Hüseyin Taştan & Bekir Aşık, 2014. "A Bayesian Estimation of Real Business-Cycle Models for the Turkish Economy," Ekonomi-tek - International Economics Journal, Turkish Economic Association, vol. 3(2), pages 27-50, May.
    15. Andrés Fernández & Adam Gulan, 2015. "Interest Rates, Leverage, and Business Cycles in Emerging Economies: The Role of Financial Frictions," American Economic Journal: Macroeconomics, American Economic Association, vol. 7(3), pages 153-188, July.
    16. C. Bora Durdu, 2006. "Quantitative Implications of Indexed Bonds in Small Open Economies: Working Paper 2006-12," Working Papers 18245, Congressional Budget Office.
    17. Andrés Fernández & Adam Gulan, 2015. "Interest Rates, Leverage, and Business Cycles in Emerging Economies: The Role of Financial Frictions," American Economic Journal: Macroeconomics, American Economic Association, vol. 7(3), pages 153-188, July.
    18. Lim, G.C. & McNelis, Paul D., 2008. "Computational Macroeconomics for the Open Economy," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262123061, January.
    19. Nan Li, 2011. "Cyclical Wage Movements in Emerging Markets Compared to Developed Economies: the Role of Interest Rates," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 14(4), pages 686-704, October.
    20. Enrique G. Mandoza & Vivian Z. Yue, 2008. "A solution to the default risk-business cycle disconnect," International Finance Discussion Papers 924, Board of Governors of the Federal Reserve System (U.S.).
    21. Enrique G. Mendoza & Vivian Z. Yue, 2008. "A Solution to the Disconnect between Country Risk and Business Cycle Theories," NBER Working Papers 13861, National Bureau of Economic Research, Inc.
    22. C. Bora Durdu, 2006. "Are Indexed Bonds a Remedy for Sudden Stops?," Computing in Economics and Finance 2006 11, Society for Computational Economics.
    23. Nan Li, 2007. "Cyclical Wage Movements in Emerging Markets Compared to Developed Economies: A Contractual Approach," Discussion Papers 06-026, Stanford Institute for Economic Policy Research.

    More about this item

    Keywords

    financial intermediation; open-economy business cycles; interest rates; capital inflows;

    JEL classification:

    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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