Real Business Cycles in Emerging Countries: The Role of Nonlinearity

Abstract

We quantify the relative importance of trend productivity shocks and financial frictions in a standard small open economy solved up to the second order and estimated with Bayesian methods based on data for emerging countries. We find that trend productivity shocks play an important role in explaining business cycles in emerging economies. In the second order solution, debt is riskier and precautionary saving is higher, which weakens the role of financial frictions and transitory productivity shocks. Although financial frictions in the quadratic model do not amplify transitory productivity shocks as much as they do in the linear model, they are still important to capture the downward-sloping autocorrelation function of the trade balance-to-output ratio.

Keywords: Emerging Economy, Real Business Cycle Models, Financial Frictions, Non-linearity

JEL Classification: E32, F43