Emerging Market Business Cycles: The Role of Labor Market Frictions

Abstract

The banks and their balance sheets have been in the epicenter of the recent European sovereign debt crisis. This paper studies sovereign risk by explicitly modeling its connection to bank capital and balance sheets. Higher sovereign risk worsens bank balance sheets by squeezing their profits and thereby tightening their capital requirements. In turn, banks' lending to firms fall and output declines since firms require working capital to produce. Lower output increases sovereign risk further, creating a negative feedback loop.

Emerging Market Business Cycles: Recent Advances

“…With the amplification introduced by the collateral constraint, consumption might drop more than output and the external sector might move in the opposite direction to the movement in output. Boz et al (2012) explores the role of labor market frictions à la Mortensen and Pissarides (1994) and Pissarides (2001) in amplifying Total Factor Productivity (TFP) and interest rate shocks and accounting for the salient features of EME business cycles. Similar to Neumeyer and Perri (2005) …”

“…I survey Neumeyer and Perri (2005), and Uribe and Yue (2006), Oviedo (2005), Aguiar and Gopinath (2007), Garcia-Cicco, Pancrazzi and Uribe (2010), Mendoza (2010), Boz, Daude, and Durdu (2011), Fernandez-Villaverde, Guerron-Quintana, Rubio-Ramirez, and Uribe (2011), and Boz, Durdu, and Li (2012). All of these papers build on the model provided by Mendoza (1991).…”

“…Further tightening the collateral constraint leads to a further decline in the variability of consumption relative to output, and the countercyclicality of the net exports also declines. Boz et al (2012) examines the role of labor market frictions à la Mortensen and Pissarides (1994) and Pissarides (2001) in amplifying Total Factor Productivity (TFP) and interest rate shocks. Similar to Neumeyer and Perri (2005) Mendoza and Yue (2012).…”

Robustness, information–processing constraints, and the current account in small open economies

“…That model would be significantly less tractable than the one we use, because it involves multiple state variables. 11 See Neumeyer and Perri (2005), Aguiar and Gopinath (2007), Boz et al (2010) among others. 12 It is worth noting that although both robustness (RB) and CARA preference (i.e., Caballero, 1990 andWang, 2003) increase the precautionary savings premium via the intercept terms in the consumption functions, they have distinct implications for the marginal propensity to consume (MPC).…”

“…Here we follow Aguiar and Gopinath (2007) by dividing the small economies into emerging and developed economies and use annual data from World Development Indicators. 7 Boz et al (2010) also report the empirical autocorrelation of the current account and the correlation between the current account and real GDP in emerging countries, and examine how labor market frictions can improve the model's predictions on these dimensions. 8 In this paper, we assume that there is only one shock to net income.…”