Ebook Emerging Market Business Cycles Revisited: Learning about the Trend
Some of the key stylized facts regarding economic fluctuations in emerging market economies seem at odds with the neoclassical theory of business cycle fluctuations for small open economies. In particular, it has been a challenge for these models to generate a higher variability of consumption relative to output along with a negative correlation between the cyclical components of the trade balance and output as observed in the data.
The present paper underscores learning about the “nature” of shocks in explaining the aforementioned features of emerging market business cycles. To do so, we build a small open economy model in which the agent in an emerging market economy observes all the past and current realizations of TFP shocks and knows the stochastic properties of the distributions of trend growth and transitory components, but does not observe the realizations of these components. Using the available information, she forms expectations about trend growth (or permanent) and transitory (or cycle) components of total factor productivity (TFP, henceforth) shocks using the Kalman filter.
Under imperfect information, the agent assigns some probability to the TFP shocks being permanent even when they are purely transitory. This mechanism by itself, however, would not be sufficient for the model to generate permanent-like responses. Because, just like purely transitory shocks being interpreted as partly permanent, purely permanent shocks would also be interpreted as partly transitory. In other words, every shock, regardless of its nature, would be processed the same way.
When signals are modeled as trend plus noise, this mechanism can allow permanent shocks to dominate leading the model to generate permanent-like responses only if the variance of trend shocks exceed that of the noise. However, when the signals are modeled as trend plus cycle, even when the variability of the trend shocks relative to cycle is less than one, the model can generate permanent-like responses.
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