Real Business Cycles in Emerging Countries?

Recently, a number of studies have departed from the mainstream view that in order to explain economic fluctuations in emerging markets, theoretical models must take explicitly into account the role of policy and market failures. This line of research argues that business cycles in emerging countries can be explained well using a neoclassical model featuring no distortions and driven solely by shocks to total factor productivity. Finn Kydland and Carlos Zarazaga (2002), for instance, adopt a strong view by arguing that the RBC model can replicate satisfactorily the “lost decade” of the 1980s in Argentina. More recently Mark Aguiar and Gita Gopinath (2007) have suggested that an RBC model driven primarily by permanent shocks to productivity can explain well business cycles in developing countries. These authors acknowledge the fact that shocks impinging upon emerging countries are numerous and of different natures but argue that their combined effect can be modeled as an aggregate shock to total factor productivity with a large nonstationary component. In addition, they argue that the neoclassical model is an adequate framework for understanding the transmission of such shocks. In this paper, we undertake an investigation of the hypothesis that an RBC model driven by a combination of permanent and transitory shocks to total factor productivity can account satisfactorily for observed aggregate dynamics in developing countries. To this end, we conduct an econometric estimation of the parameters of a small open economy RBC model using Argentine and Mexican data over the period 1900–2005. Our use of long time series is motivated by what we believe is an important drawback of existing studies advocating the ability of the RBC model driven by permanent technology shocks to explain business cycles in developing countries. Namely, the use of short samples both for the characterization of observed business cycles and for the estimation of the parameters of the theoretical model, particularly those defining the stochastic process of the nonstationary productivity shock. We find that, when estimated over the long sample, the RBC model driven by permanent and transitory productivity shocks does a poor job at explaining observed business cycles in Argentina and Mexico along a number of dimensions. One such dimension is the trade balance– to-output ratio. Specifically, the RBC model predicts that the trade balance–to-output ratio is a near random walk, with a flat autocorrelation function close to unity. By contrast, in the data, the highest autocorrelation coefficient of the trade balance–to-output ratio takes place at the first order and is less than 0.6, with higher-order autocorrelations converging quickly to zero. In addition, we find that the RBC model fails to match several other important features of the business cycle in emerging countries. In particular, in Argentina and Mexico, as well as in many other emerging countries, consumption is significantly more volatile than output. The RBC model fails to capture the observed excess volatility in consumption, and in the case of Mexico it actually predicts consumption to be significantly less volatile than output. Also, the model Real Business Cycles in Emerging Countries?