World Real Interest Rates and Business Cycles in Open Economies: a Multiple Shock Approach

We examine the importance of world real interest rate shocks in explaining business-cycle fluctuations in open economies using a stochastic dynamic model of a small open economy. We argue that a good proxy of the world real interest rate is not available. Moreover, the world interest rate fluctuations might be correlated with domestic disturbances such as technology or preference shocks. To overcome these problems, we use our model as a vehicle to estimate the world real interest rate series. Using data on the endogenous variables of the model, and utilizing the orthogonality conditions associated with the Euler equations, we estimate the policy functions of the endogenous state variables. We recover the exogenous shocks of the model, namely the world real interest rate, technology, preference, and depreciation disturbances. The novelty of our approach is that we examine the behavior of the unobservable shocks given data on observable endogenous variables of the model. We employ variance decomposition methods to evaluate the impact of world real interest rate disturbances quantitatively on domestic business cycles fluctuations. The results of this examination suggest that interest rate shocks can play an important role in explaining cyclical variation in a small open economy.