Working Paper: NBER ID: w14875
Authors: Jess Fernández-Villaverde; Pablo A. Guerrón-Quintana; Juan Rubio-Ramírez; Martín Uribe
Abstract: This paper shows how changes in the volatility of the real interest rate at which small open emerging economies borrow have a quantitatively important effect on real variables like output, consumption, investment, and hours worked. To motivate our investigation, we document the strong evidence of time-varying volatility in the real interest rates faced by a sample of four emerging small open economies: Argentina, Ecuador, Venezuela, and Brazil. We postulate a stochastic volatility process for real interest rates using T-bill rates and country spreads and estimate it with the help of the Particle filter and Bayesian methods. Then, we feed the estimated stochastic volatility process for real interest rates in an otherwise standard small open economy business cycle model. We calibrate eight versions of our model to match basic aggregate observations, two versions for each of the four countries in our sample. We find that an increase in real interest rate volatility triggers a fall in output, consumption, investment, and hours worked, and a notable change in the current account of the economy.
Keywords: Volatility; Emerging Economies; Real Interest Rates; Stochastic Volatility
JEL Codes: C32; C63; F32; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| changes in the volatility of real interest rates (E43) | decreases in output (E23) |
| changes in the volatility of real interest rates (E43) | decreases in consumption (E21) |
| changes in the volatility of real interest rates (E43) | decreases in investment (E22) |
| changes in the volatility of real interest rates (E43) | decreases in hours worked (J22) |
| standard deviation of the innovation associated with a country's spread increases by one standard deviation (O57) | households adjust their consumption, labor, investment, and savings decisions (E21) |
| households adjust their consumption, labor, investment, and savings decisions (E21) | lower consumption (E21) |
| lower consumption (E21) | decreases in investment (E22) |
| decreases in investment (E22) | reduced output (E23) |
| decreases in investment (E22) | decline in marginal productivity of labor (J29) |