Journal of International Economics 56 (2002) 299–327
www.elsevier.com/locate/econbase
Explaining business cycles in small open economies
‘How much do world prices matter?’
*M. Ayhan Kose
Graduate School of International Economics and Finance, MS-021, Brandeis University, Waltham,
MA 02454, USA
Received 27 May 1998; received in revised form 20 October 2000; accepted 7 April 2001
Abstract
This paper analyzes the role of world price shocks – fluctuations in the prices of capital,
intermediate, and primary goods, and in the world real interest rate – in the generation and
propagation of business cycles in small open developing countries. I construct a stochastic
dynamic multi-sector small open economy model. The model is a variant of the specificfactors
model and reflects the major structural characteristics of developing economies. I
utilize variance decomposition methods to quantitatively evaluate the impact of world price
shocks. The results indicate that world price shocks account for a significant fraction of
business cycle variability in developing countries. © 2002 Elsevier Science B.V. All rights
reserved.
Keywords: Business cycles; Relative prices
JEL classification: F41; E31; E32; D58
1. Introduction
Small open developing countries differ from developed economies along several
dimensions. They rely heavily on a narrow range of primary commodities for their
export earnings. These earnings are highly unstable due to recurrent and sharp
fluctuations in the relative prices of primary commodities. Moreover, a significant
*Tel.: 11-781-736-2266; fax: 11-781-736-2269.
E-mail address: akose@brandeis.edu (M.A. Kose).
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PII: S0022-1996(01)00120-9
300 M.A. Kose / Journal of International Economics 56 (2002) 299–327
fraction of their export revenues is used to pay back their large foreign debt.
Developing countries also depend heavily on imported capital goods and intermediate
inputs for domestic production. In light of these structural features, it is
not difficult to see that fluctuations in world prices – fluctuations in the prices of
primary, capital, and intermediate goods, and in the world real interest rate – could
have an important impact on business cycle fluctuations in small open developing
1
countries.
The objective of this paper is to examine the role of world prices in inducing
business cycle fluctuations in these countries using a stochastic dynamic business
cycle model. The model embodies the main structural characteristics of small open
developing economies. In particular, the model provides an environment in which
the dynamic interactions between world price shocks and business cycle fluctuations
in traded and non-traded goods sectors, and several factors of production
including imported capital goods, imported intermediate inputs, non-tradable and
inelastically supplied capital (land), and labor can be studied. I also examine
impulse responses to investigate the propagation of economic fluctuations generated
by world price shocks and domestic productivity shocks.
This paper is closely related to some of the recent literature that studies the
2
importance of these price fluctuations. Mendoza (1995) was the first paper to
analyze the quantitative importance of terms of trade shocks in driving business
cycles using a dynamic stochastic small open economy model. In Mendoza’s
model domestically produced capital goods in the non-tradable goods sector are
inelastically supplied, and capital is perfectly substitutable between exportable and
importable goods producing sectors. Also, terms of trade shocks do not have a
direct impact on the dynamics of the non-traded sector in his model, because the
only endogenous factor in that sector is domestic labor. His paper focuses only on
aggregate output fluctuations and he finds that terms of trade disturbances explain
56% of output variation.
This paper extends Mendoza’s work by developing a richer production structure
that captures several empirically relevant features of developing economies. In
particular, I consider a variant of the specific factors model with two sectors:
production of exportable primary goods features diminishing returns as these
goods are produced with imported capital, domestic labor, and inelastically
supplied land. The non-traded final goods sector employs capital, imported
intermediate inputs, and domestic labor. This production structure, while capturing
the important role played by land in the production process, limits the substitution
effects across different types of factors, and reduces the volatility of primary sector
1
See Agenor and Montiel (1996) for a brief analysis of the relationship between world price
fluctuations and economic activity in developing countries.
2
Baxter (1995) provides an extensive survey of the research program, which investigates a variety of
issues associated with the generation and transmission of business cycles in open economies using
stochastic dynamic general equilibrium models. Kim (1994); Senhadji (1998); Mendoza (1991, 1995).