Can World Real Interest Rates Explain Business Cycles in a Small Open Economy?

27 Pages Posted: 20 Feb 2000

See all articles by William F. Blankenau

William F. Blankenau

Kansas State University - Department of Economics

M. Ayhan Kose

Development Prospects Group at the World Bank

Kei-Mu Yi

University of Houston - Department of Economics; Federal Reserve Banks - Federal Reserve Bank of Minneapolis

Date Written: November 1999

Abstract

While the world real interest rate is potentially an important mechanism for transmitting international shocks to small open economies, much of the recent quantitative research that studies this mechanism concludes that it has little effect on output, investment, and net exports. We reexamine the importance of world real interest rate shocks using an approach that reverses the standard real business cycle methodology. We begin with a small open economy business cycle model. But, rather than specifying the stochastic processes for the shocks, and then solving and simulating the model to evaluate how well these shocks explain business cycles, we use the model to back out the shocks that are consistent with the model's observable endogenous variables. Then we use variance decompositions to examine the importance of each shock. We apply this methodology to Canada and find that world real interest rate shocks can play an important role in explaining the cyclical variation in a small open economy. In particular, they can explain up to one-third of the fluctuations in output and more than half of the fluctuations in net exports and net foreign assets.

Keywords: world interest rates, business cycles, dynamic stochastic general equilibrium models, small open economy

JEL Classification: D58, E32, F41

Suggested Citation

Blankenau, William F. and Kose, M. Ayhan and Yi, Kei-Mu, Can World Real Interest Rates Explain Business Cycles in a Small Open Economy? (November 1999). FRB of New York Staff Report No. 94. Available at SSRN: https://ssrn.com/abstract=206208 or http://dx.doi.org/10.2139/ssrn.206208

William F. Blankenau

Kansas State University - Department of Economics ( email )

Manhattan, KS 66502-4001
United States

M. Ayhan Kose

Development Prospects Group at the World Bank ( email )

1818 H Street, NW
Washington, DC 20433
United States

Kei-Mu Yi (Contact Author)

University of Houston - Department of Economics

Houston, TX 77204-5882
United States

Federal Reserve Banks - Federal Reserve Bank of Minneapolis ( email )

90 Hennepin Avenue
Minneapolis, MN 55480
United States

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