Emerging Market Fluctuations: the Role of Interest Rates and Productivity Shocks

Business cycles in emerging markets are characterized by high levels of volatility in income, investment, and net exports. Consumption is more volatile than income, and net exports are highly countercyclical (see Aguiar and Gopinath, 2007). Furthermore, the interest rates faced by these economies are highly volatile and negatively correlated with income, as described in Neumeyer and Perri (2005). In this paper, we adopt a standard stochastic business cycle model of a small open economy and allow the economy to be driven by productivity shocks that have permanent and transitory components, as well as by shocks to the interest rate process. We then estimate the role of the different processes in explaining the business cycle behavior of emerging markets. In Aguiar and Gopinath (2007), we examine an economy driven exclusively by shocks to productivity. Productivity shocks in this context may be viewed as manifestations of deeper frictions in the economy, such as changes in monetary, fiscal, and trade policies. For instance, Restuccia and Schmitz (2004) provide evidence of a 50 percent drop in productivity in the petroleum industry in Venezuela within five years of its nationalization in 1975. Similarly, Schmitz and Teixeira (2004) document almost a doubling of productivity in the Brazilian iron ore industry following its privatization in 1991. We view such dramatic changes in productivity following reforms and the undoing of reforms as characteristic of emerging markets. Several emerging markets also experience terms-of-trade shocks that display