Wednesday, December 6, 2017 | 3:30pm-5:00pm | Room 333, HSBC Business School Building

Abstract

In this paper, we document difference in comovement of real exchange rates (RER) with other macroeconomic aggregates between emerging economies and developed small open economies, especially the significant and negative correlation between real interest rate and RER in emerging market economies. Motivated by these observations, we include the RER and real interest rate data in the estimation of a two-sector small open economy RBC model with tradable and non-tradable goods.  We find that the deviation of law of price and the collateral constraint with pecuniary effect induced by relative price changes are important in explaining the RER dynamics and comovement observed in emerging market economies. First, to explain the RER volatility, the relative price of non-tradable goods generated by the non-tradable temporary technology shock is not enough. Hence, we introduce imperfect substitution between home and foreign tradable goods into standard two-sector models to allow for deviation from law of one price in tradable goods and this helps to generate RER volatility relative to output which is consistent with data. Second, we introduce collateral constraints on firms' borrowing,  so that the pecuniary effect of exchange rate change can help to explain the negative correlation between RER and real interest rate and the countercyclical real interest rates. Our model with these features does well in matching business cycle moments in emerging market economies, including those related to RER. Finally, our estimation results also identify country premium shock as the major force in driving RER dynamics and output fluctuations, thus providing another evidence supporting the important role of country premium shock and financial frictions in explaining emerging market business cycle.