Interest Rates and Business Cycles in Emerging Economies.The Role of Financial Frictions

Countercyclical country interest rates have been shown to be both a distinctive characteristic and an important driving force of business cycles in emerging markets. In order to capture this, most business cycle models of emerging economies have nonetheless relied on ad hoc and exogenous countercyclical interest rate processes. We offer a solution to this shortcoming by embedding a financial contract `a la Bernanke et al. (1999) into a standard RBC model of a small open economy. Because of the existence of agency problems between foreign lenders and domestic borrowers, this financial structure allows us to fully endogenize the existence of an external finance premium that drives country interest rates. We then take the model to emerging economies data and show that this modification allows to properly account for many of the stylized facts of business cycles in emerging economies, not least the strong volatility and countercyclicality of interest rates. A key mechanism in the model that allows to properly account for this dynamics is a countercylical leverage. We then build a new dataset for leverage in emerging economies and present evidence that this variable is indeed strongly countercyclical in the data.