Comparing Financial Frictions Models of the Business Cycle in Emerging Countries

Abstract

This study estimates a financial friction model and three extensions solved up to the third order using a Bayesian approach, and compare the estimated model implications for business cycles in emerging countries. Our empirical results are as follows: First, we find that adding a country premium shock substitutes for the role of a trend productivity shock in explaining the countercyclical trade balance. Second, the debt elasticity of the country premium and portfolio adjustment costs are interchangeable in generating the downward-sloping autocorrelation function of the trade balance-to-output ratio. Third, a model with both the debt-elastic interest rate and portfolio adjustment costs improves a model with only the debt-elastic interest rate. Regardless of the order of approximation, this model yields consistent estimated results, especially for the relative contribution of transitory and trend shocks to productivity. Lastly, second- and third-order approximations should be considered to capture the asymmetric persistence of the trade balance during boom-and-bust cycles.

Keywords: Emerging economy, Financial frictions, Small open economy model, Nonlinearity

JEL Classification: E32, F43