One of the most dynamic areas of macroeconomic research in the last decades is that of Real Business Cycle (RBC) models. Since the seminal work by Kydland and Prescott (1982), a number of papers have tested the abilities of neoclassical general equilibrium models to account for economic fluctuations. The original framework of Kydland and Prescott has been extended to included labor market rigidities (Hansen, 1985), taxes and government expenditures (McGrattan, 1994a), money and inflation (Cooley and Hansen, 1995), open economies (Backus et al, 1995), and increasing returns to scale in production (Weber, 2000). Each of these extensions has been successful in solving the limitations of calibrated models to replicate particularities of the data and can provide richer explanations of business cycles, although at the cost of increasing complexity.
Although RBC models have been successful when applied to developed economies, their abilities in replicating the data of developing countries remain largely untested. In the case of Chile, there are only a few noteworthy exceptions. This paper provides the first systematic exploration of RBC models to the Chilean data, starting with the original Kydland and Prescott framework and introducing increasing degrees of complexity in the analysis. The purpose of this exercise is to test the capacities of RBC models to (1) replicate the salient characteristics of the observed aggregate fluctuations of the economy in the 1986-1998 period, and (2) provide insights regarding the contribution of fiscal and monetary policies to the cycle.
The challenge to RBC models posed by the Chilean experience is formidable. First, in the 1986-1998 period the economy experienced a rapid but unstable pace of growth. Although GDP grew at an average annual rate of 7.5%, it also experienced significant year to year fluctuations, from a high 10.1% growth in 1989 to only 2.1% in 1990. In contrast, in the same period GDP growth in the US was 2.6% and fluctuated within a narrower range of -1% to 4%. Second, in the 1986-1998 period Chile experienced a remarkable reduction in inflation, from a high annual rate of 27% in 1989 to only 4.6% in 1998, which suggests that the contribution of both nominal and real fluctuations might have played an important role during the period.
Third, the economic structure of a developing country such as Chile differs markedly from that of industrial economies precisely in those key underlying parameters that govern the mechanics of RBC models. Particularly in terms of factor shares in GDP, the stock of capital, the size and composition of government expenditures, the composition of consumption and investment, and the size of technological shocks.
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Testing Real Business Cycle Models in an Emerging Economy
