World Interest Rate, Business Cycles, and Financial Intermediation in Small Open Economies

P. Marcelo Oviedo ()

Staff General Research Papers Archive from Iowa State University, Department of Economics

Abstract: The consensus about the ability of the standard open-economy neoclassical growth model to account for interest-rate driven business cycles has changed over time: whereas early research concluded that business cycles are neutral to interest-rate shocks, more recent investigations suggest that these shocks can explain a large extent of the business cycles of a small open economy when firms borrow to pay for their labor cost before cashing their sales. The first goal of this paper is to show that the recently found effectiveness of interest-rate shocks to cause business cycles rests more on the statistical properties of the shocks than on the working-capital constraint; in particular, recent results are only valid when the level and volatility of the interest rate are high and when the interest rate is negatively correlated with total factor productivity. The paper also shows that interest-rate shocks cannot be the sole driving force of business cycles even when the canonical model is augmented to include a working-capital constraint. The second goal of the paper is to quantitatively explore the dynamic properties of the neoclassical growth model extended to include financial intermediation. It is shown that the extended model with external effects in financial intermediation can match the negative correlation between GDP and a domestic borrowing-lending spread in emerging countries if the economy is subject to productivity shocks but not when the model is subject to both productivity and interest-rate shocks.

Keywords: financial intermediation; open-economy business cycles; interest rates; capital inflows (search for similar items in EconPapers)
JEL-codes: F32 F34 F41 (search for similar items in EconPapers)
Date: 2005-05-17
New Economics Papers: this item is included in nep-dge, nep-mon and nep-sea
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Citations: View citations in EconPapers (42)

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