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Can real world interest rates explain business cycles in small open
economies?
With Ayhan Kose and Kei-Mu Yi, Journal
of Economic Dynamics and Control. June 2001, Vol. 25, pp. 867-889.
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 re-examine 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 and 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.
