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

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 that co-vary with the interest rate. ∗[email protected], [email protected]. Prepared for the Tenth Annual Conference of the Central Bank of Chile, “Current Account and External Financing,” to be held in Santiago, Chile, November 9 and 10, 2006. We thank Claudio Radatzz, Manuel Marfan and Kevin Cowan for very useful comments. We also thank Deepa Dhume for excellent research assistance.