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The Role of Interest Rates and Productivity Shocks in Emerging Market Fluctuations

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Author Info
Mark Aguiar
Guita Gopinath

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Abstract

In this paper we use a quantitative model to explore the potential frictions that distinguish emerging market business cycles from developed small open economies. Following Aguiar and Gopinath (2007) we allow total factor productivity (TFP) to have a stationary and an integrated component. We also allow for shocks to the consumption and investment Euler Equations that operate through the interest rate. These “wedges” represent changes in the intertemporal marginal rate of transformation, which may be due to changes in observed interest rates, unobserved borrowing constraints, or other financial frictions. We estimate the model using data from Mexico and Canada. We show that interest rate shocks orthogonal to domestic TFP fail to explain the behavior of emerging markets. We then allow for interest rates to respond to/co-vary with productivity shocks. We find that emerging market business cycles appear to be driven by large shocks to trend income combined with relatively small transitory shocks tha co-vary with the interest rate.

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Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 445.

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Date of creation: Dec 2007
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Handle: RePEc:chb:bcchwp:445

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  1. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Blackwell Publishing, vol. 48(2), pages 289-309, April. [Downloadable!] (restricted)
  2. James A. Schmitz, Jr. & Arilton Teixeira, 2004. "Privatization's impact on private productivity: the case of Brazilian iron ore," Staff Report 337, Federal Reserve Bank of Minneapolis. [Downloadable!]
  3. Pablo A. Neumeyer & Fabrizio Perri, 2004. "Business Cycles in Emerging Economies: The Role of Interest Rates," NBER Working Papers 10387, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  4. Aguiar, Mark & Gopinath, Gita, 2006. "Defaultable debt, interest rates and the current account," Journal of International Economics, Elsevier, vol. 69(1), pages 64-83, June. [Downloadable!] (restricted)
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  5. Arellano, Cristina, 2008. "Default risk and income fluctuations in emerging economies," MPRA Paper 7867, University Library of Munich, Germany. [Downloadable!]
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  6. V. V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2005. "Sudden Stops and Output Drops," Levine's Bibliography 122247000000000880, UCLA Department of Economics. [Downloadable!]
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  7. Schmitt-Grohe, Stephanie & Uribe, Martin, 2003. "Closing small open economy models," Journal of International Economics, Elsevier, vol. 61(1), pages 163-185, October. [Downloadable!] (restricted)
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  8. Aiyagari, S Rao, 1994. "Uninsured Idiosyncratic Risk and Aggregate Saving," The Quarterly Journal of Economics, MIT Press, vol. 109(3), pages 659-84, August. [Downloadable!] (restricted)
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