Business Cycles with Financial Intermediation in Emerging Economies
59 Pages Posted: 6 Aug 2015 Last revised: 20 Aug 2015
Date Written: August 5, 2015
Financial frictions coupled with shocks to the country premium have been identified as driving force in emerging market business cycles. This paper argues that sudden stops in capital inflows are not necessarily identified by shocks to the country premium, but might in some cases be due to exogenous funding constraints of domestic banks. I augment a standard small open economy business cycle model with leveraged capital importing banks that are subject to financial shocks that mimic a sudden change in investor preference for emerging market assets. Estimating the model in a Bayesian approach using Mexican data, I find that once controlling for the foreign interest rate, its role for the explanation of macroeconomic dynamics is reduced significantly. In particular over the global financial crisis, financial sector shocks have played a larger role for the explanation of investment and current account dynamics. The presented financial sector model is preferred on the basis of the marginal data density in a comparison with two popular alternative approaches to financial frictions.
Keywords: Open-economy business cycles; Financial intermediation; Emerging markets; Capital flows; Financial frictions
JEL Classification: F32, F42, F44
Suggested Citation: Suggested Citation