Working Paper 04-4
by Mark Aguiar and Gita Gopinath

Business cycles in emerging markets are characterized by strongly counter-cyclical current accounts, consumption volatility that exceeds income volatility, and dramatic “sudden stops” in capital inflows. These features contrast with those of developed, small open economies and highlight the uniqueness of emerging markets. Nevertheless, we show that both qualitatively and quantitatively a standard dynamic stochastic, small open economy model can account for the behavior of both types of markets. Motivated by the observed frequent policy-regime switches in emerging markets, our underlying premise is that these economies are subject to substantial volatility in their trend growth rates relative to developed markets.

Consequently, shocks to trend growth--rather than transitory fluctuations around a stable trend--are the primary source of fluctuations in these markets. When the parameters of the income process are structurally estimated using GMM for each type of economy, we find that the observed predominance of permanent shocks relative to transitory shocks for emerging markets and the reverse for developed markets explain differences in key features of their business cycles. Lastly, employing a VAR methodology to identify permanent shocks, we find further support for the notion that, for emerging economies, the cycle is the trend.

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