Emerging Market Business Cycles: The Cycle is the Trend Emerging Market Business Cycles: The Cycle is the Trend

November 1, 2010

Motivation for the Research
While business-cycle fluctuations in developed markets may have moderated in recent decades, business cycles in emerging markets are characterized increasingly by their large volatility and dramatic current account reversals. In this paper the authors explore whether a standard real business-cycle model can qualitatively and quantitatively explain business-cycle features of both emerging and developed small open economies.

Research Approach
Having observed frequent policy-regime switches in emerging markets, the authors take as their underlying premise that emerging markets are subject to substantial volatility in their trend growth rates relative to developed economies. Consequently, shocks to trend growth-rather than transitory fluctuations around the trend-are the primary source of fluctuations in these markets.

The authors document several features of economic fluctuations in emerging and developed small open economies and show how a standard real business-cycle model reproduces to a large extent the business-cycle features of both emerging and developed economies. The stochastic, dynamic, general-equilibrium model has two productivity processes-a transitory shock around the trend growth rate of productivity and a stochastic trend growth rate.

The authors estimate the parameters of the stochastic process using generalized method of moments; data from a prototypical emerging market, Mexico; and, as a benchmark, data from a developed small open economy, Canada. Using the Kalman filter and the estimated parameters, they decompose the observed Solow residual series for Mexico into trend and transitory components and then feed the decomposed Solow residuals for Mexico through the model. Finally, using VAR analysis, they explore the premise that "the cycle is the trend," for emerging markets, using the methodology of King, Plosser, Stock, and Watson to perform a variance decomposition of output into permanent and transitory shocks.

Key Findings

  • A standard business-cycle model can explain important differences between emerging markets and developed economies once the composition of shocks that affect these economies is appropriately modeled. . Specifically, a model that accounts appropriately for the predominance of shocks to trend growth relative to transitory shocks characteristic of emerging markets reproduces the current account and consumption behavior observed at business-cycle frequencies.
  • When calibrated to the much more stable growth process of developed small open economies, the same model generates weaker cyclicality of the current account and lower volatility of consumption, consistent with the data.
  • The estimated process for productivity in Mexico implies a trend volatility that is over twice that of the transitory shock; in the case of Canada, this ratio is roughly one-half.

Without recourse to additional market imperfections, a standard model does surprisingly well in explaining emerging markets-particularly the facts about consumption and the current account-once the composition of shocks is modeled appropriately. However, this is not to say that market imperfections are not important in emerging markets. In particular, these features may be necessary for understanding why what we term productivity is so volatile in emerging markets.

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