Business Cycle Persistence in Developing Countries: Can a DSGE Model with Production Chains and Sticky Prices Reproduce the Stylised Facts?

It is well documented that business cycles of developed countries are characterised by persistent output fluctuations, and this has been the subject of much theoretical interest. However, the case for developing countries has been somewhat neglected in the literature. This paper addresses this imbalance revealing that whilst both developed and developing countries exhibit persistent output fluctuation, there is a significant positive relationship between the magnitude of output persistence and the level of economic development, with more economically developed countries exhibiting higher output persistence than less developed countries. To further investigate this relationship, the vertical production chain model of Huang and Liu (2001) was implemented. This model lends itself to such an analysis, as by altering the number of production stages (N) it is possible to represent economies at different levels of development. The results support the key premise of Huang and Liu (2001), namely that there is a strong positive relationship between the number of production stages and the magnitude of output persistence. However, the effect of increasing the number of stages is severely limited by the share of the composite of stage n-1 goods in i’s production (γ). This was particularly poignant in the modelling of the US and UK; calibration gave low values of γ which effectively inhibited the model from generating anywhere near enough persistence to match the observed level. Nonetheless, after abstracting from the US and UK results, there was found to be a strong significant positive relationship between the magnitude of output persistence generated by the model and economic development. However, a very significant finding of this analysis is that the model overestimates output persistence in high inflation countries and underestimates output persistence in low inflation countries. This has important implications not only for this model, but also for any economist attempting to construct a business cycle model capable of replicating the observed patterns of output persistence. JEL Classification: E31, E32, E52