Real Business Cycles Versus Financial Frictions Models for Small Open Economies

Abstract

Is a real business cycle model extended with non-stationary technology shocks able to describe small open economies or are credit market imperfections necessary in addition? This study addresses this question by providing evidence of the relative ability of a model with and without financial frictions to replicate the data for 12 emerging and 12 developed small open economies. Our main finding is that including fi nancial frictions improves the fit of the model in all the studied emerging market economies and only in 5 developed small open economies. Also, we find that permanent technology shocks are relatively more important in emerging market economies expanding the analysis in Aguiar and Gopinath (2007). In the process of comparing models, we provide a set of parameter estimates for a large set of countries that could serve as a guide for future studies.