“Tropical” Real Business Cycles? A Bayesian Exploration

Can frictionless small open economy models driven solely by technology shocks account for business cycles in developing countries? We do not find evidence of it. We build a DSGE model that jointly includes a variety of real perturbations in addition to technology shocks, such as procyclical fiscal policies, terms of trade fluctuations, and perturbations to the foreign interest rate coupled with financial frictions. We estimate it using Bayesian methods on high and low frequency data from a developing —and “tropical”— country, Colombia. We find interest rate shocks to be crucial and that financial frictions play a central role as propagating mechanisms of transitory technology shocks. These two driving forces alone can account well for the observed properties of the Colombian business cycle. Other structural shocks, such as terms of trade fluctuations and level shifts in the technology process, do not appear to be relevant in the past decade and a half, but their importance increases when a longer span of data is considered.