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| December 1999Number 94 |
| JEL classification: F41, E32, D58 |
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Authors: William Blankenau, M. Ayhan Kose, and Kei-Mu Yi While the world real interest rate is potentially an important mechanism for transmitting international shocks to small open economies, much of the recent quantitative research that studies this mechanism concludes that it has little effect on output, investment, and net exports. We reexamine the importance of world real interest rate shocks using an approach that reverses the standard real business cycle methodology. We begin with a small open economy business cycle model. But, rather than specifying the stochastic processes for the shocks, and then solving and simulating the model to evaluate how well these shocks explain business cycles, we use the model to back out the shocks that are consistent with the model’s observable endogenous variables. Then we use variance decompositions to examine the importance of each shock. We apply this methodology to Canada and find that world real interest rate shocks can play an important role in explaining the cyclical variation in a small open economy. In particular, they can explain up to one-third of the fluctuations in output and more than half of the fluctuations in net exports and net foreign assets. |
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For a published version of this report, see William Blankenau, Kei-Mu Yi and Ayhan M. Kose, "Can World Real Interest Rates Explain Business Cycles in a Small Open Economy," Journal of Economic Dynamics and Control 25, no. 6-7 (June-July 2001): 867-89. |
27 pages / 211 kb
