Business cycles in small developed and middle income economies: The role of external shocks and financial frictions

Chapter one, "Business Cycles in Small Developed Economies: The Role of Terms of Trade and Foreign Interest Rate Shocks" studies the ability of a standard DSGE small open economy model to reproduce two regularities of business cycles in Small Developed Economies (SDEs): Consumption is highly procyclical and as volatile as output, and real net exports are counter cyclical. Previous studies could not reproduce them for normal values for the intertemporal elasticity of substitution and business cycles driven by productivity shocks. They have rather set lower values for such elasticity or unrealistically persistent shocks. This chapter shows that a standard DSGE small open economy model can reproduce these regularities if the terms of trade and foreign interest rate shocks are considered as additional sources of business cycles fluctuations. While these shocks create smaller fluctuations in GDP than productivity shocks, they produce larger procyclical fluctuations in consumption and investment relative to output, and counter cyclical fluctuations in net exports. Furthermore, they reinforce each other as their innovations are negatively cross-correlated.; Chapter two, "Financial Frictions and Business Cycles in Middle Income Countries", studies whether a standard DSGE Small Open Economy Model can replicate the business cycles regularities in Middle Income Countries (MICs), which differ from those in SDEs not only because output is more volatile, but also because consumption and real net exports are more volatile relative to output. This chapter explores whether considering two financial frictions, into an otherwise standard DSGE small open economy model, can reconcile theory and data for MICs without considering different preferences or shocks' persistence, but rather market imperfections often cited in the emerging world literature, an imperfect access to the foreign capital market and asymmetric financing access across tradable and non tradable sectors. The model with an imperfect access to the foreign capital market, identified as an external borrowing constraint, can replicate the counter cyclical and volatile path of real net exports, but generates counter cyclical employment and excessive consumption smoothing. Adding the second friction, identified as sector specific labor financing wedges, allows the model to reproduce the cyclical properties of these other variables as well.